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Amid financial turmoil, bonds rally

Published Oct. 17, 2014

Last week's stock market drop and wild gyrations may have been wrenching for investors, but they can't really be called a surprise. After 27 months with no significant decline and with many valuation measures signaling caution, a chorus of pundits has been predicting a stock market pullback and higher volatility.

But along with the turmoil, there was a surprise: On Wednesday, the yield on the 10-year United States Treasury note hit 1.85 percent, its lowest level since May 2013, extending a yearlong Treasury bond market rally that almost no one predicted.

The recent volatility of stocks and the unpredictability of interest rates is a potent reminder to most investors to have a diversified mix of stocks and bonds and stick to a simple asset allocation plan. "What happened this week isn't unusual, and it isn't abnormal," said Francis Kinniry, a principal in Vanguard's investment strategy group. "Stocks are a high-risk, high-return asset."

Even though interest rates seem pretty close to rock bottom, some bond experts are saying they could drop even further.

"We've been telling our investors for a decade that just because bond yields are low doesn't mean the direction has to be up," Kinniry said. "A lot of people confuse the level with the direction. We agree the level is low, so return expectations are low. But it's not as simple as gravity, that just because they're low means they have to go up."

This week, some Federal Reserve board members sounded as if the Fed might delay its long-anticipated rate rise expected in mid 2015. Some economists are even calling for a resumption of its quantitative easing program, the central bank's bond-buying program scheduled to end this month — all moves that could cause rates to drop even further and prolong the bond rally.

Given recent strength in the U.S. economy, the decline in the unemployment rate and the Fed's repeated intention to tighten monetary policy over the next year, no wonder hardly anyone anticipated this year's bond market rally. But there were a few lonely voices.

In his list of "15 Surprises for 2014," issued in January, Douglas Kass, president of Seabreeze Partners Management and a widely followed market pundit, predicted "slowing global growth" (surprise No. 1); "stock prices decline" (surprise No. 3); and "bonds outperform stocks" (surprise No. 4).

Those have been remarkably accurate so far, though Kass readily acknowledges that he was far too bearish in 2013, when his forecasts were "way off the mark." When I reached him last week at his office in Palm Beach, Kass said he was sticking by his predictions that stocks would end the year at their lows and that bonds would show a 10 percent return.

"I think we're approaching an 'aha' moment," he said, "when investors realize that growth isn't going to emerge in the months ahead. The central banks have blunt tools, and they've reached the limit of what they can do. As Peggy Lee put it, 'Is that all there is?' "

Kass expects the bond rally to continue and is among those who suspect the Fed will delay raising rates.

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"People are losing sight of the fact that the Fed hasn't raised rates since June 2006," he said. "I don't see them raising rates for two or three more years. That will be another surprise for the markets."

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