Bond Investors, Don't Be Fooled: This Rebound is Just a Bear-market Rally

Surges in the bond market do not automatically signal the onset of a bull market, a crucial point to bear in mind amidst the striking bond market rally witnessed since the lows of October. Vanguard's Extended Duration Treasury Index ETF (EDV), serving as a market proxy, has surged by over 30%, significantly uplifting investor sentiment and prompting many to speculate that the bond bear market from 2020 to 2023 has come to an end.

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However, historical context, as illustrated in the accompanying chart, reveals that rallies of a similar magnitude have transpired at least twice before since the initiation of the bond bear market in the summer of 2020. After the first rally, spanning from March to December 2021, the bear market resumed with Vanguard's EDV plummeting by 50% over the subsequent 10 months. Similarly, after the second rally, occurring from October to December 2022, the ETF experienced a 34% decline in the following 10 months.

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While the past two rallies turned out to be bear market rallies, it does not necessarily imply that the current surge is following the same pattern. However, this historical perspective serves as a reminder that merely gauging the magnitude of the rally is insufficient to conclude the initiation of a new bull market.

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Edward McQuarrie, an emeritus professor at California's Santa Clara University, emphasizes the recurring nature of bear market rallies during severe bear markets, stating, "Horrible bear markets see ferocious bear market rallies… There's every reason to expect [the bond bear market that began in 2020, the worst in U.S. history by several measures] will, from time to time, feature bear market rallies of equivalent force."

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The skepticism surrounding the recent rally's automatic implication of a new bull market also aligns with theoretical considerations. The market's future trajectory is contingent on subsequent events rather than preceding ones. Whether the bond market experiences an upward trend in 2024 hinges on outcomes surpassing current investor expectations.

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Examining interest rate forecasts for 2024 provides additional insights. The futures market projects that the fed funds rate will conclude the year around 3.75%, a decrease from the recent 5.33%. Given that current bond prices already incorporate this expectation, a substantial rally is not anticipated from current levels unless the fed funds rate declines significantly below 3.75%. Conversely, a resumption of the bear market is expected if the fed funds rate does not reach that level or, worse, rises from its current position.

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Edward McQuarrie underscores the challenge of determining, in real time, whether the market is entering a bull market or experiencing a bear market rally. If such knowledge were readily available, market dynamics would have already adjusted to reflect that information. As a result, the current juncture leaves investors in a state of uncertainty, emphasizing the unpredictable nature of market shifts and the need for a cautious approach amid the ongoing bond market dynamics.