Written by Bryan Perry 

...Some very high-profile market gurus - namely DoubleLine's Jeff Gundlach and legendary value hedge fund manager Stanley Druckenmiller - are predicting 10-year Treasury yields will rise to 6% by 2018 and GDP growth will reach the same 6% rate by 2019. Anticipation of those numbers could take the 10-year Treasury Note yield above 3% fairly soon, in anticipation of further Fed tightening.

Investors are having to rapidly adjust to this incredible turn of events in an almost overnight fashion that is very unsettling for those holding tight to their long-dated bond holdings. The only solace is that all bonds mature at par value - if you elect to hold on to long-dated maturities. Either way, the great bond rally of the past eight years is officially over - at least until the next recession comes around. 

It would seem that both Gundlach and Druckenmiller are getting some early tailwinds for their forecasts. U.S. Treasuries took their cue from the economic calendar as positive news translates to a downhill slope for bond prices.

• Durable goods orders jumped by 4.8% (month over month) in October (versus consensus estimates of just 1.1%).
• In addition, the Commerce Department announced that GDP growth surged at a 3.2% annual pace in the third quarter, up from its initial estimate of 2.9%, as consumer spending was revised up to a 2.8% annual pace, from 2.1% initially estimated.
• Also, existing home sales rose to 5.6 million in October vs. 5.49 million in September,
• and corporate profits jumped 6.6% in the third quarter. 

The hits keep on coming:

• The Institute for Supply Management (ISM) announced that its manufacturing index rose to 53.2 in November, up from 51.9 in October. This was the highest the ISM manufacturing index has been in the past five months and well above economists' consensus estimate of 52.5. The new orders component rose to 53 in November, up from 52.1 in October. All this is good news for continued strong GDP growth. (Source: Institute of Supply Management, December 1, 2016)
• Looking forward, the Atlanta Fed's GDPNow model forecast is now at 2.9% for fourth-quarter U.S. real GDP growth, so the U.S. economic recovery looks to be gathering speed from the sluggish pace that prevailed for most of 2016. That said, interest rate markets have priced in a lot more growth and inflation and the rationale for the Fed raising interest rates to stem inflation and rising GDP now seems inevitable.

While stronger U.S. economic data has been supporting higher Treasury yields, the big unknowns are the size and composition of any fiscal stimulus coming in 2017. The Republican-controlled White House and Congress are expected to enact some combination of tax cuts and infrastructure spending next year. In general, the larger the infrastructure package, the more it should push nominal interest rates higher.

The recent pronounced move in Treasury yields has priced in a good portion of future expectations to where the move looks overdone, with many blown-out dividend growth stocks that have strong organic growth in earnings and dividend payouts now trading at hugely attractive prices. It's as if a 7.5 earthquake rippled through many income-paying sectors all at once, taking down several terrific growth and income stocks, providing a multi-year opportunity for income investors to pounce on... Then again, the current trading landscape resembles attractive, tropical waters where a shark sighting has been reported. It sure looks tempting to jump in, but not at the expense of having a bite taken out of one's income portfolio.

If the chorus of respected Wall Street mavens gets any louder on the topic of hotter economic growth going forward, then by all means, these seemingly terrific entry points for the dividend payers are only going to get more terrific. It's just too early to tell, and because of that, it would be wise to stand aside and see just how high the market wants to take interest rates heading into 2017 before attempting to bottom-fish too heavily. We're in the kind of market where more than one shoe could drop for bond investors if the data keeps improving at a better-than-expected pace. Taking partial positions in great dividend stocks is a more highly recommended strategy or dollar cost averaging as the market permits.

Taking Stock of the Bond Market

Within the bond market smorgasbord, the ultimate sweet spot on the yield curve is the 5-7 year maturity class. History is strongly on the side of owning maturities in this timeframe when rates are on the rise, as the bond market tends to crush everything with maturities beyond seven years. The best hidden opportunity for fixed-income investors will be to buy into the junk-bond and low-end investment grade (BBB rating) space through closed-end funds and Unit Investment Trusts (UITs) that have durations that don't reach beyond 2022. As the economy strengthens, this debt class gains more balance sheet credibility as the investment proposition becomes very compelling, since their maturities are reasonably visible.

The chart below compares Treasuries, investment grade corporate bonds, and junk bonds. These three lines show how junk bonds began to outperform other categories during the early part of the third quarter. I view this performance spread as one that will be maintained against the backdrop of an improving economy where investors are willing to take on more credit risk while shortening up maturities. 

The ground has definitely shifted under the bond market. Bond investors can no longer be complacent about their long-term holdings. The inflation genie looks to finally be out of the bottle and has taken a seat in the locomotive of the GDP train that is now leaving the station. This scenario can be materially negative for bond portfolios that don't have short duration periods and investors that are over-weighted long-dated maturities need to consider the implications of what is already "history in the making."