What It Means That Treasury Bonds Currently “Hotter” Than Stocks

WHEN Treasury bonds are hotter than stocks, it’s a sign that something is very wrong with the stock market.

That has been the pattern lately, though.

In a reprise of the flight to safety that occurred during the financial crisis of 2008 and early 2009,

people have been parking cash in Treasuries and fleeing stocks, which, of course, have had better long-term returns historically.

WHEN Treasury bonds are hotter than stocks, it’s a sign that something is very wrong with the stock market.

That has been the pattern lately, though.

In a reprise of the flight to safety that occurred during the financial crisis of 2008 and early 2009,

people have been parking cash in Treasuries and fleeing stocks, which, of course, have had better long-term returns historically.

“It’s classic risk-aversion,” said Gregg S. Fisher, chief investment officer at Gerstein Fisher, a financial advisory firm in New York. “We’ve seen this happen before.”

This time around, the great cash migration started with the debt crisis in Greece and elsewhere in Europe, not in the United States,

but the effects on the American stock and bond markets have nonetheless been severe.

Last month, for example, the Standard & Poor’s 500-stock index dropped 8.2 percent.

The Dow Jones industrial average fell 7.9 percent, making it the worst May for stocks, in percentage terms, since 1940.

For people holding Treasury bonds, it’s been one of the best of times.

In May, long-term Treasury mutual funds outperformed every traditional category of stock fund, according to Morningstar data, returning 5 percent.

Ominously, only bear market funds — those dedicated to bets on a stock market decline — fared better. They returned 8 percent.

And as demand for Treasuries has risen, yields have plummeted, while prices, which move in the opposite direction, have soared.

This price surge has turbocharged long-term Treasury mutual funds, despite the paltry yields of the underlying bonds, according to this article in the New York Times.

People with cash in money market funds are getting a much, much lower yield than that — only 0.07 percent annually for the largest funds, on average, according to Peter G. Crane, the president of Crane Data of Westborough, Mass.

That’s better than the 0.05 percent average of earlier this year — but not enough to make a difference.

“It’s still awfully close to zero,” he said.

“The amazing thing is that even at these rates, when you’re getting virtually no return on your money at all, people are still moving cash into money market funds. It’s sobering.”

It is also sobering that a vast majority of economists and market strategists were forecasting a different chain of events.

Treasury yields were universally expected to be rising, not falling, as the United States recovered from a deep recession.

The domestic economy is, in fact, growing, and corporate profits have been rising, but the European crisis has overturned many expectations.

Barry Knapp, United States equity strategist at Barclays Capital, got some of the outlines right, if not the details.

“Sometimes, you’re correct for other reasons,” he said.

He had predicted that after a long run upward, the stock market would fall in the first half of the year, and it has, putting stocks in “correction” territory.

So far, so good.

But Mr. Knapp had thought that the stock market decline would be set off by a tightening of monetary policy by the Federal Reserve,

which has operated on an emergency basis since the onset of the financial crisis in the United States.

The Fed hasn’t tightened.

Instead, to keep the economy stable in the face of Europe’s problems, it has held short-term interest rates near zero.

In addition, it reopened emergency swap lines with European central banks last month, to help maintain liquidity there.

Similarly, Joseph H. Davis, Vanguard’s chief economist, had said it was likely that long-term interest rates would be rising and that the Fed would be moving short-term rates up more dramatically.

That will still happen eventually, he said, but the timing is far from certain.

“We got it wrong,” he said cheerfully. “Of course, we did warn that there was a good chance that might happen.”

In a detailed 16-page analysis of the bond market in March, Mr. Davis and several Vanguard associates deconstructed Treasury yields and projected rates using the “forward yield curve,”

a standard calculation of the market’s assessment of future interest rate levels.

This kind of analysis makes use of the information embedded in prices, but it won’t tell you what will happen to the bond and stock markets if something unexpected arises — like Greece suddenly running into a credit wall.

What comfort can be drawn from these uncertain markets?

First, the Vanguard study found that even a climb in Treasury yields needn’t be devastating for well-run long-term bond portfolios,

because higher yields can more than compensate for lower bond prices.

Such management may not be easy to do on your own, but the study found that many mutual funds have handled the transition well in past market cycles.

Second, at the moment, investment-grade bonds are very richly priced in comparison with stocks, several analysts said.

Mr. Knapp says he expects that the S.& P. 500 will rise to 1,210 by the end of the year, or 13.6 percent from its current 1,064.88,

and that the chances for strong longer-term stock returns are favorable. (The outlook for Treasuries is not positive, he said.)

MR. DAVIS said that there is a very “strong correlation” between low Treasury yields and subsequent strong economic growth.

And there is a weaker but still significant connection between low yields and high stock returns.

In short, at current prices, it would appear that there is some reason for long-term optimism for stock investors.

For the short run, alas, more volatility is probably in order.

“The problems in Europe, for one, aren’t going away any time soon,” Mr. Knapp said.

People seeking safety are likely to face very low yields for a while.

Unless you’re focused on a distant horizon, it may be a difficult summer.