Yields on the benchmark 10-year Treasury note jumped by 27 basis points (0.27%) over the first three days of this week. Driehaus Capital says this was only the second such three-day spike since the fall of 2011. Speculation about the timing of the first interest rate hike by the Federal Reserve and a rise in European bond yields are both contributing factors.

This year is showing signs of being a sequel to 2013. Since reaching a short-term closing low of 1.85% on April 17, yields have risen to 2.31% as of this afternoon. In 2013, yields rose from 1.63% on May 2 to 2.14% on June 4, 2013. The 10-year Treasury note event eventually ended 2013 with a yield of 3.03%.

Nobody knows with any certainty where yields are headed over the forthcoming seven months. Though this year’s jump is swift and reflects speculation about the timing of a change in monetary policy, like the move two years ago, there is never a guarantee of history repeating. Even the voting members of the Federal Open Market Committee (FOMC)—in aggregate—seem uncertain about when rates should be raised.

The chatter about the direction of future of monetary policy is too narrow in scope. While a change to a tightening stance by the Federal Reserve would be a notable event, focusing solely on the timing of the first rate increase is akin to completely missing the elephant standing smack-dab in the middle of the room. What matters is not so much the timing of the first rate hike, but rather what comes after it. Will the Fed make symbolic rate increases or will it undergo a series of hikes pushing up rates notably higher? The answer to this question, like the answer to the preceding question, is “data dependent.”

There is a second elephant in the room to be aware of: bond liquidity. Liquidity, in this case, refers to how easy it is to buy and sell securities. As basic economic principles state, whenever there is a disproportionate number of sellers to buyers, prices will drop. (Prices and yields are inversely related, so as prices drop, yields rise.) An imbalance between buyers and sellers is being blamed by some for helping to cause the recent jump in bond yields. Whether this is a full-grown elephant or a baby elephant is hard to say, especially since liquidity is relative to the type of bond being discussed. Treasuries enjoy a large and active market, while corporate and municipal bonds can experience far less trading. Nonetheless, even concerns about a liquidity crunch can lead to volatility.

The monetary policy and liquidity elephants can be ignored by those who currently own actual bonds and have the intention of holding them until maturity. There simply is no reason to react as long as the issuers can reasonably be expected to fulfill their obligations. Those looking to buy bonds may find more attractive prices due to the recent move in bond yields. Bond fund investors—a group that includes me—will endure price volatility. Given the move in bond yields (which reduces prices), it would not surprise me to see negative second-quarter returns for bond funds [mutual funds, exchange-traded funds (ETFs) and closed-end funds], barring a complete reversal in yields over the next few weeks. That’s okay. We’re hiring bond managers to guide our fixed-income dollars through a variety of market environments. When potholes appear, the ride will be bumpy. It’s inevitable.

Those of you are nervous should keep a few things in mind. First, calls for when the FOMC will begin raising rates have been and continue to be premature. At some point they won’t be, but this threshold has not been reached yet. Second, the timing and magnitude of future rate increases is an even bigger unknown. Furthermore, nobody knows what the yield of the 10-year Treasury note will be at the end of this year, much less what it will be at the end of 2016 or even further out into the future. Even those who claim to have insight don’t know. Third, if you hold a bond (an actual bond, not a bond fund) to maturity, you will receive the par value of the bond, plus you will be paid interest no matter what happens to the bond market. Finally, over the long term, bond returns have been uncorrelated to stock returns. As such, bonds can smooth out the overall volatility of a diversified portfolio.

• Liquidity: The Hidden Risk in the Municipal Market – Earlier this year, Nicholos Venditti of Thornberg Investment Management explained how liquidity impacts bonds.
  
• Getting a Handle on the Bond Market – This AAII Classroom lesson explains how the bond market operates, including how it differs from the stock market.
  
• How Closely Do You Follow Changes in Bond Yields? – Tell us on the AAII.com Discussion Boards
  

It’s going to be a fairly quiet week in terms of what’s on the calendar. H&R Block (HRB), which reports on Monday, will be the only S&P 500 member to announce earnings.

The week’s first economic report of note will be the Labor Department’s April Job Openings and Labor Turnover (JOLTS) Survey, released on Tuesday. Thursday will feature May retail sales, May import and export prices and April business inventories. The May Producer Price Index (PPI) and the University of Michigan’s preliminary June consumer sentiment survey will be released on Friday.

The Treasury Department will auction $24 billion of three-year notes on Tuesday, $21 billion of 10-year notes on Wednesday and $13 billion of 30-year bonds on Thursday.

Even with a slight increase, optimism remains below 30% for a fifth consecutive week in the latest AAII Sentiment Survey—a streak not seen since early 2003. Neutral sentiment continues to stay at an unusually high level, while pessimism is still at below-average levels.

Bullish sentiment, expectations that stock prices will rise over the next six months, edged up 0.3 percentage points to 27.3%. Even with the slight increase, optimism is below its historical average of 39.0% for the 13th consecutive week.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, increased slightly (0.2 percentage points) to 48.0%. The minor change keeps neutral sentiment at or above 45% for a ninth consecutive week—the longest such streak in the survey’s 28-year history. This week is also the 22nd consecutive week with a neutral sentiment reading above its historical average of 31.0%.

Bearish sentiment, expectations that stock prices will fall over the next six months, declined 0.5 percentage points to a five-week low of 24.6%. The decline keeps pessimism below its historical average of 30.0% for a ninth consecutive week and for the 19th week this year.

As noted above, bullish sentiment is now below 30% for a fifth consecutive week. This is the longest such streak since a seven-week stretch between January 16 and February 27, 2003.

Bullish sentiment readings below 28.6% are unusually low, and unusually low levels of optimism have typically been followed by better-than-average six-month and 12-month returns for the S&P 500. Similarly, the S&P 500 has realized better-than-average returns when neutral sentiment is at an unusually high level, as it currently remains. For more information, see my May 21 AAII Investor Update, Unusually High Neutral Sentiment Often Followed by Good Returns. (There is no guarantee, however, that history will repeat.)

Causing some AAII members to be cautious or pessimistic are prevailing valuations, recent price volatility, geopolitical events, the pace of economic growth, the impact of the stronger dollar on earnings growth and worries that a notable decline in stock prices could occur. Keeping other AAII members encouraged are the ongoing bull market, sustained economic expansion, earnings growth and still-accommodative monetary policy.

Bullish: 27.3%, up 0.3 points
Neutral: 48%, up 0.2 points
Bearish: 24.6%, down 0.5 points


Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%

Fixed-income allocations fell to their lowest level in a year, as individual investors remain frustrated with low interest rates. Cash allocations, meanwhile, rose for a second consecutive month as equity allocations declined.

Stock and stock fund allocations declined 0.2 percentage points to 67.7%, the lowest level since January. Even with the decline, equity allocations remained above their historical average of 60% for the 26th consecutive month.

Bond and bond fund allocations fell 0.7 percentage points, to 15.5%. Fixed-income allocations were last lower in December 2013 (15.2%). The historical average is 16.0%.

Cash allocation rose 1.0 percentage points, to 16.9%. Cash allocations were last higher in October 2014 (18.7%). Despite the increase, May was the 42nd consecutive month with cash allocations below their historical average of 24%.

The rise in cash allocations occurred as neutral sentiment (as measured by the weekly AAII Sentiment Survey) has stayed at or above 45% for eight consecutive weeks and above average for 21 consecutive weeks. Though cash allocations have risen for two consecutive weeks, allocations to stocks and stock funds remain high as investors fret over low interest rates and see a lack of attractive alternatives for their portfolio dollars. Speculation about an interest rate increase occurring this year may also have contributed to the decline in fixed-income allocations.

May’s special question asked AAII members what predominately influences their decision to increase or reduce exposure to bonds and bond funds. About 38% of respondents said interest rates influence their bond allocation. Approximately 13.9% said that current low yields affect their decision. Roughly 12% of respondents noted that they do not allocate to bonds at all. Other responses were evenly distributed among factors such as market volatility, market valuations or behavior, expected withdrawal, rebalancing and the economy.

Here is a sampling of the responses:

• “I will invest in bond funds when I feel the value in security outweighs the risks of owning only stocks.”
• “I’ve been staying away from bonds for several years, I just don’t like their dynamics right now.”
• “My allocation of bonds is based on current economic conditions and my portfolio mix.”
• “Interest rates. I buy bonds and hold them to maturity. When interest rates are so low that utility stocks are clearly a better buy, I don’t renew in bonds.”

• Stock and Stock Funds: 67.7%, down 0.2 percentage point
• Bond and Bond Funds: 15.5%, down 0.7 percentage point
• Cash: 16.9%, up 1.0 percentage point

• Stocks: 33.1%, up 0.9 percentage point
• Stock Funds: 34.6%, down 1.1 percentage points
• Bonds: 3.6%, up 0.3 percentage point
• Bond Funds: 11.8%, down 1.0 percentage point

Take the Asset Allocation Survey.

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