The Year of Trading Dangerously

(Originally published here.)

A funny thing happened on the way to the Great Rotation from bonds to stocks: Fixed-income assets have crushed equities so far this year.

That’s the exact opposite of what everyone was predicting at the end of 2013. When the CFA Institute asked its members which asset class would have the highest total returns in 2014, chartered financial analysts overwhelmingly thought that stocks would do better than bonds.

Towers Watson’s 2014 Global Survey of Investment and Economic Expectations, which is based on a survey of investment managers, concluded that U.S. interest rates would probably be little changed in 2014. Franklin Templeton’s Global Investor Sentiment Survey, which was conducted at the beginning of January, found that two-thirds of U.S. investors expected interest rates to rise in 2014. Instead, interest rates have declined, especially for long-maturity securities.

That has boosted bond prices even as U.S. stocks have gone nowhere.

How could so many smart people have gotten things so wrong? One explanation is that asset prices at the beginning of 2014 already reflected expectations that stocks would do better than bonds — purely a function of investors’ irrational assumption that the future would be just like the recent past. But equities and interest rates had no reason to rise further unless investors became even more optimistic about the U.S. economy’s prospects.

Then remember what happened as we started the year: weak U.S. data that was partly blamed on the rough winter; inflation slowed in the big rich countries; Chinese economic growth slumped; and tensions mounted amid the situation in Russia and Ukraine. Together they may have damped the optimism that colored investor sentiment.

The pattern of optimism giving way to dull reality is a familiar one for observers of U.S. markets. Just check out this great chart from analysts at Bank of America Merrill Lynch, courtesy of Saxo Bank A/S chief economist Steen Jakobsen.

Each colored line shows the expected path of short-term interest rates — a decent proxy for the state of the economy — while the black line along the bottom shows what has actually happened. For the past five years, traders have consistently (and wrongly) bet that growth is about to accelerate and interest rates will rise. In other words, irrational exuberance lives. If interest rates and stocks finally do go up, it probably won’t be until everyone has stopped expecting it.

To contact the writer of this article: Matthew C. Klein at

To contact the editor responsible for this article: James Greiff at


About Matthew C. Klein

I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.
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