Introduction: I believe that both sentiment and fundamentals may be coming together to allow U.S. Treasury bonds to appreciate in price (i.e., decline in yield). Accordingly, I recently increased my allocation to long-term fixed income vehicles relative to my stock market allocation. This article explains the rationale.
I am a private investor and not a financial adviser; nothing herein constitutes investment advice.
Background: Since the Volcker tight money policy of 1979-82, the upward trend in stock prices has been associated with a similar upward trend in bond prices. The general public thinks of declining interest rates, shown here interactively, as simply a phenomenon like the weather, but what causes declining rates is higher prices for fixed income securities. At every new cycle low in interest rates going back to the early '80s, calls have been made in the financial media that because of inflation and deficit spending, interest rates had nowhere to go but up, and we were at the final low in rates. Wrong! We hear the same calls now. Perhaps they will finally be correct. But...
Short-term rates have, unthinkably from a 1981 or a Y2K perspective, been pinned near zero for over four years. A 2-3% guaranteed yield from a longer-term bond beats zero from a T-bill for an unknown period; thus the longer that zero interest rates persist, the more there is a sort of magnetic force pulling long rates towards zero. (This has obviously been the Japanese experience.) Given the role the U.S. dollar plays in the world's financial system, it is not necessary for there to actually be deflation for this to continue to happen.
Many periods of interest rate declines had nothing to do with recessions. This includes last year, when long rates dropped about 100 basis points (almost one full percent) when inflation was barely changing and the economy was expanding. Similar phenomena have included good years for the stock market and the economy such as 1985, 1995 and 1998.
Thus nothing herein is predicting a recession or a bear market for stocks.
This discussion thus focuses on Treasury bonds and the supply-demand dynamics for them, and suggests a trend change is a reasonable possibility in the short- or intermediate-term time frame.
Let's begin with sentiment analysis before moving to the more important topic of fundamental analysis.
A. Sentiment: "Risk on":
1. Retail is heavily margined. BofA Merrill Lynch and Zero Hedge created this chart:
The brown line shows the aggregate level of margin debt (left scale; January data). My guess - just a guess - is that it is higher now along with the stock averages, perhaps equal to or above the June 2007 level.
The black peaks above and below the zero line (right scale) show whether investors are net liquid or net indebted at brokerage accounts. At the time the data were collected, investors were indebted to their brokers -- a dangerous situation that could lead to forced liquidations.
The chart therefore shows a combination of high, rising margin debt and dropping, negative net cash balances. This pattern has marked major and intermediate peaks in interest rates the last few years.
For example, in June 2007, when both variables were similar to where they are now, interest rates peaked around 5.25%. In February through April 2011, a similar though less extreme pattern also marked a major top in interest rates. A similar phenomenon occurred last year.
Correlations to past events guarantee nothing about the future, of course. But if past is prologue, the likely beneficiary of such a mood change would be Treasury bond prices-- even if stocks did not correct much if at all.
2. The positioning of speculators in the 30-year T-bond has been bearish for several months in a row. This level of net shorts has marked the start of every move up in price for the long bond since 2007. In this FINVIZ chart, the green line represents positioning of commercial hedgers and the red and blue lines represent speculators' positioning.
Thus there is fuel in the futures market; speculators who are short may turn to bulls, as has happened more than once the past few years.
3. In the opposite vein, the new "risk on" index is the Russell 2000, which trades on the futures market also per FINVIZ. Speculators are long a record amount there, as well (i.e., commercial hedgers are heavily short):
The three points so far simply present a good contrarian set-up, but contrary analysis can lose you a lot of money if that's all you go by. The next two points and the rest of the article make the affirmative case that 1) there are fundamental reasons why rates may decline soon and 2) a well-known bond star may be a "champion" behind whom tactical bond bulls could rally.
B. Fundamentals: The case for a bull move in bonds:
1. Bloomberg.com laid the groundwork with an article on March 11:
Cheapest Treasuries Since 2011 Are Alluring to Gundlach
The sudden slowdown in U.S. inflation has left Treasuries at the cheapest levels in almost two years...
Yields on 10-year notes, the benchmark measure for everything from home loans to corporate bonds, reached an 11- month high of 2.08 percent on March 8. The securities pay interest 0.88 percentage point higher than the personal consumption expenditures index deflator, the Fed's favored inflation gauge, the widest gap since May 2011.
Jeffrey Gundlach, whose $39.5 billion DoubleLine Total Return Bond Fund beat 97 percent of its peers last year in part by avoiding U.S. government debt, said on March 5 that "relative value has swung more to the favor" of Treasuries...
The PCE gauge, which measures household spending, rose 1.2 percent in January from a year earlier, the smallest increase since October 2009 and down from a recent high of 2.9 percent in September 2011, the Commerce Department said March 1.
Another measure of the relative value of U.S bonds with maturities of more than 10 years shows them yielding 0.44 percentage point more than comparable global sovereign debt. That makes the securities the cheapest since August 2011, according to Bank of America Merrill Lynch indexes...
Global supply of the highest-quality bonds, as measured by ratings companies, is poised to fall to $6 trillion from $10 trillion before the global financial crisis, according to an International Monetary Fund report in January. Reforms such as the Dodd-Frank financial-overhaul law and global regulations set by the Bank for International Settlements in Basel, Switzerland, require institutions to hold more top-graded debt as a cushion against potential losses.
"The shortage of debt and the sluggish recovery and employment situation have paved the way for low yields for some time," James Sarni, senior managing partner at Payden & Rygel in Los Angeles, which oversees $75 billion, said on March 6 in a telephone interview.
The above speaks for itself. Bloomberg is making a bull case for rates to drop.
2. Jeff Gundlach, "the new bond king," has done more than "swing" toward Treasuries. Reuters interviewed him recently, and he was just plain bullish:
DoubleLine's Gundlach shifts gears, now buys U.S. bonds
Jeffrey Gundlach, one of the world's leading bond fund managers, has reversed his once-bearish stance on government debt, saying he has bought "more long-term Treasuries in the last month" than in the last four years.
Gundlach said he started buying benchmark 10-year U.S. Treasury notes in the last month after yields popped above 2 percent, because he sees value there relative to other asset classes, including stocks, which he said are "overbought."
"I bought more long-term Treasuries in the last month than I've bought in four years. I am a fan of Treasuries now. I wasn't a fan of Treasuries in July," said Gundlach, chief investment officer and chief executive officer of DoubleLine Capital.
His Los Angeles firm manages $56 billion in assets.
Gundlach's views are a change in tune from July, when he correctly predicted that government bonds could be at a peak in price. Ten-year notes were then yielding 1.48 percent, within striking distance of the 1.44 percent level touched in the previous month, the lowest going back to the early 1800s, based on data gathered by Reuters.
"They looked cheap at a yield above 2 percent, compared to certain riskier assets, which had gone up in price over the last six months while Treasury prices fell," he said. "Also, owning 10-year Treasuries at yields above 2 percent provides an offset to credit risk we are taking elsewhere in the portfolio."
Gundlach recently has become famous (notorious?) for publicly going short AAPL around $625 and predicting a $425 downside target. More recently, he called for a major move up in Japanese stocks and a major move down in the yen. So, he's got a hot hand. When he finds preservation of capital with a 10-year Treasury to be so important that he considers it to be "cheap," he is sending a message that he thinks that risk assets are ahead of themselves - and I and probably others note that point of view with respect.
To summarize the above, speculators are long stocks and short Treasuries, both on margin; Bloomberg has for the first time I can remember made an affirmative case for Treasuries, and a "bond king" with a hot hand finds a 2% yield on the 10-year T-note very attractive.
This suggests that there are good contrarian and affirmative cases for interest rates to drop in the months ahead that would reward investors in Treasuries. Adding to the strength of this argument, rates have stopped rising and may have started falling again in several important government bond markets.
C. Timing: May be right for bonds: Rates are stable to dropping globally. Even though Japan's new government is threatening to go from modest deflation to 2% inflation, the 10-year Japanese Government Bond (JGB) has dropped 5 basis points the last few days from 68 basis to 63 basis points. (Rates were much higher than that when the new government was elected.)
Rates have for now stabilized at very low levels in other important government bond markets such as Germany and the UK.
Germany's rates are much lower than those of both the UK and the U.S. Germany is the ultimate "risk off" bond market for the eurozone, but the U.S. is the ultimate risk off bond market for the world. Thus it would not surprise me if the U.S. ended up at some point with lower interest rates than Germany.
In talking about timing, I am not talking about day-to-day timing, though; the time frame is more like weeks or even months, given that bonds pay interest. With bonds, I do not mind being early.
D. Other bullish points:
1. The three decade-long bond bull market has been quiet and unpublicized. Yet the total return from bonds since both they and stocks bottomed in price in the early 1980s has paralleled and roughly equaled that from stocks. Jeremy Grantham looks equally askance at US stocks and bonds, finding each asset class similarly overvalued on a 7-year total return basis. If he is correct, then stock bulls may wish for continued very low interest rates: the syndrome of rising rates, rising earnings and lower P/Es could reprise the 1965-1982 stagflation syndrome for stocks.
2. The Federal government has begun to shrink the deficit as a share of GDP. The sequester means that nominal Federal spending is going to be roughly flat year on year. Plus, Congress now estimates that Obamacare-related taxes will be much greater than originally projected. The shrinkage of the deficit as a share of GDP means that the economy increasingly needs to stand on its own. However, nominal (not real) GDP has only been increasing at 3.5% year on year based on the most recent data (pdf - see p. 2). With the second derivative of Federal deficit spending declining, inflation could drop further. This would enhance the attractiveness of Treasuries.
3. A lot of economic growth has once again been coming from risky lending practices. Marginal growth in auto sales is now being driven by subprime borrowers, per this recent article:
Still, 43.2 percent of new car loans in the fourth quarter were written for those with subprime credit scores, according to Experian. That is the highest percentage of new car loans going to subprime buyers since late 2007.
"Late 2007"- a good time to own Treasuries- though few believed that to have been possible at the time. This sort of news about bubble credit market activity has been seen for months now:
NEW YORK, Sept 13 (IFR) - Double B rated issuers are again setting records in the US primary market with the average yield-to-worst on the Barclays US high-yield index dipping to its lowest ever level of 6.334% on Wednesday.
That's nearly 30 basis points (BP) tighter than the 6.615% record set in May of last year.
Against this backdrop, issuers are rushing into the market to lock in incredibly low rates. On Tuesday, homebuilder D.R. Horton grabbed a record low 10-year yield after pricing, via RBS sole books, a US$350m senior bullet offering at 4.375% at par.
That's the lowest yield on a 10-year note ever priced, according to IFR data.
We saw the same thing in the run-up to the Great Recession.
Eventually, what has happened in similar economic cycles to date is that credit excesses get corrected at some unpredictable point. Then, stocks and junk bonds sell off, and Treasuries- the ultimate safe haven in the minds of investors- get bid up sharply in price. It's impossible to time, but I fear that this dynamic is at real risk of occurring again.
4. The world has been judged by RecessionAlert to be in recession. This is generally deflationary and increases the chances of a financial accident somewhere, sometime. By definition, such an event is not "in" prices--it is a surprise. One thinks of Russia's bankruptcy in 1998 and the onset of the eurozone crisis in 2011 as examples of events that brought Treasury rates way down without materially affecting the US economy.
5. Demographics and wealth distribution favors bonds. The investor base in the US is aged and aging. I'm an example. I am on the leading edge of the Baby Boom and retired young. I am far more risk-averse than when I was working. I can cut my expenses if inflation erodes the value of the pure income part of my portfolio (primarily muni bonds). But if the stock market goes the way of Japan's, I can never make the lost principal back. So I look at the 2% yield on the SPDR S&P 500 ETF (NYSEARCA:SPY) and shrug. In 2009, Mr. Market required 4% from it. Maybe in 7 years, dividends will grow nicely but Mr. Market will require 6% from it. Stock prices could be halved- and stay down. There is no possible way to prove to me and my fellow boomers- or our living parents- that this will not happen.
Not only does the above apply to more and more people every day, but life is tougher for the younger generation than for mine. The same government policies that have kept home prices from crashing even farther have made it tougher for couples to comfortably afford their first home. So they have more limited investable funds after expenses than did my generation or my parent's.
Finally, pension funds, which often fight the last war, are now getting religion and realizing that the only way a defined benefits plan can reasonably guarantee a return of capital is via fixed income. Stocks are simply too unpredictable over any time frame you name.
I believe that the above points will continue to weigh in favor of bonds for some time to come. If I am correct in this, stocks will gradually become better and better values, but they are not there yet (per Grantham, with whom I concur).
Finally, and perhaps most important:
6. To disdain Treasuries is to fight the Fed. I never fight the Fed. The Fed is buying Treasuries. All things being equal, I'm more comfortable being with Ben Bernanke than opposing him. To bet on higher Treasury borrowing rates any time soon-- against not only the preference of the Fed but against that of Barack Obama (through his Secretary of the Treasury)-- is to bet against the two most important people in the financial world.
E. Ways to own Treasuries: There are numerous ways for an individual to gain exposure to Treasuries. There is direct ownership of the bond. There is TLT and there are other ETFs; there are mutual funds.
More aggressive investors who wish exposure to the greater volatility of zero coupon Treasuries have at least two ETFs to choose from. These are the PIMCO 25+ Year Zero Coupon US Treasury Index ETF (NYSEARCA:ZROZ) and the Vanguard Extended Duration Treasury Index Fund (NYSEARCA:EDV). They are similar, except that I believe that EDV pays dividends and ZROZ does not. Neither has anywhere near the liquidity of TLT, however.
F. Risks: The major risks from owning Treasury bonds are inflation and capital impairment from rising rates. Then there are the more psychological risks that the funds that went into boring and potentially risky bonds would have gone into XYZ stock, which went on to double without you.
CONCLUSION: Periods of global recession or near-recession, whether or not the U.S. joined in, have been associated with declining interest rates. Given the primacy of the United States and the dollar in the global financial system, countless influences come into play regarding supply and demand for dollars (Treasuries). With the Federal Reserve locking up vast quantities of Treasuries and pinning short-term rates near zero, and with investors exposed with net negative cash balances at brokers, the time may be right for a risk off rally.
Considering the above points, the views of Jeff Gundlach and the reporting by Bloomberg, described above, lead me to be comfortable holding TLT and EDV not only for income but for possible capital appreciation.