Introduction: This continues a series of bullish articles on Treasury bonds. This began most clearly with the March 14 article, The Case For Buying Treasury Bonds Now. This was followed on April 1 by The Case For Treasuries Strengthens. Since the earlier one was written on March 13, the Vanguard Extended Duration Treasury Index ETF (EDV) has returned about 10%, far ahead of any US stock market index. While yields are lower than they were in mid-March, Treasuries retain investment merit, both for fundamental and technical reasons.
We are living in extraordinary economic and financial times.
Are long-term interest rates "too low"? With short-term rates pinned near zero, the answer is unclear. The 32-year old bond bull market started with record high interest rates. The long end has spent less than two years below its historical average of about 4.6% for the 30-year bond, and a bit longer than that for the 10-year bond. Symmetry suggests that the many years the long bond spent above 5-6% might just be followed by a similar number of years at historically low levels.
Are stocks more attractive than bonds? That's also unclear. Stocks and bonds have been engaged in mutually-reinforcing bull markets since the early 1980s, with periodic sell-offs. 30+ years ago, conventional analyses suggested that both asset classes were undervalued; similarly, most analyses suggest that stocks are overpriced except in relation to interest rates. And we all "know" that bonds are overpriced. Yet their prices keep trending higher (interest rates have been trending lower).
This article makes the tactical case that yet lower interest rates in the months ahead are likely; though it is difficult to define "likely." I have investment/trading positions in various bond ETFs. These include EDV and the similar PIMCO 25+ Year Zero Coupon Treasury Index ETF (ZROZ), plus the better known fund that invests in pay (dividend-paying) Treasuries, iShares Barclays 20+ Year Treasury Bond ETF (TLT) . These were discussed in the above-linked articles and will not be re-discussed here.
Background: Below is a chart of the 10-year T-bond since 1870, when interest rates had been declining from the double-digit level they reached during the Civil War:
A mere 5% was an interest rate level only associated with wars until the late 1970s: the Civil War, World War I, and then the Vietnam War with the associated "Great Society" effort. This latter disaster forced the US off the gold standard in 1971. This ended up being followed by what amounted to a run on the dollar in the late 1970s, which was combated by the institution of extraordinarily high interest rates under the Volcker Fed beginning in October 1979.
As shown in the above chart, interest rates went to unheard of high levels by 1970. Yet those levels that were the highest in 100 years were to go and remain much higher. Eventually what had been an extraordinarily high borrowing rate for the government was considered low. Thirty years on from 1970, in Y2K, the 6 1/2+% rates then present, which appeared normal to low to virtually all contemporaries, represented what before 1969 were unheard of, exorbitant levels.
Thus it may be that the sub-3% yield on US government debt for 30 years could similarly be taken for granted as reasonable a decade from now. That at least has been the Japanese experience.
In other words, guaranteed return of principal indeed has a value, and the value placed on that might continue to increase.
With the US now basically at peace, an aging investor base may demand low inflation and might just get it.
Here's some fundamental evidence that disinflation or even "good deflation" is, to general surprise, occurring.
Fundamentals: The era of low interest rates is stimulating nothing much, though in accord with both Keynesian and Austrian economic theory, it does draw consumption forward and raise stock market asset prices. The five April regional Fed manufacturing surveys ranged from mediocre to poor. Advance March retail sales were deflationary. More broadly, the headline inflation rate used by the Bureau of Economic Analysis has just set a new cycle and, in conjunction with the core rate "validating" it, a multi-decade low (red line):
Sales trends at large corporations are now frankly deflationary:
A mere 38 percent of the 271 S&P 500 companies that had reported through Friday topped revenue estimates, with the aggregate figure actually showing a sales decline of 1.45 percent, according to Zacks Investment Research.
Year on year sales declines? Heavens forbid!
The MNI Chicago Report was out Tuesday with a second negative downside surprise. Internals were frankly recessionary:
The report was riddled with weakness and seemed to mirror patterns seen in 2011 and 2012 when minor strength in the first quarter was followed by declines later in the year.
The current reading of 49.0 on the Barometer is well below the levels seen in April 2012 of 56.2 and in April 2011 of 64.6. It also is well below the 2012 median of 54.3, the 10-year median of 57.5 and the 42-year median of 55.6...
-Production, down 1.9 to 49.9, to its lowest since September 2009 and its 10th monthly decline in the last year. March's 8.4-point setback was the largest one-month decline since October 2008.
-Order Backlogs contracted at a faster rate, down 4.4 to 40.6, also the lowest since September 2009 and well below the 2012 median of 47.9 as well as the 10-year median of 50.6. April's levels compared to 52.9 a year ago and 56.2 two years ago. Order Backlogs, or orders to be produced in the future, have been in contraction in 10 of the last 12 months.
-Inventories shed 0.4 to 40.6, its lowest since December 2009 and the fifth month in contraction in the last seven. Inventory levels have also slowed in 10 of the last 12 months.
The Federal government is injecting less spending into the economy, as deficit reduction efforts, supported by much of the electorate in the 2010 midterm Congressional election, finally take effect:
U.S. Sees First Debt Reduction Since 2007 as Revenue Rises
The U.S. Treasury Department (USGG10YR) projected it will reduce government debt this quarter for the first time in six years as tax receipts exceed forecasts and spending diminishes.
The pay-down in net marketable debt was estimated at $35 billion in the April-June period, compared with a projection three months ago for net borrowing of $103 billion, the department said in a statement today in Washington. Treasury officials also see net borrowing of $223 billion in the quarter starting July 1.
The above is a disinflationary phenomenon. This may account for the recent data from the BEA of minimal year on year increase in disposable personal income (DPI), from Table 2 of the linked economic release, Personal Income and Outlays (March 2013). Table 3 breaks down DPI by month. It has hardly risen since last August, given measurement errors. This is without adjustment for a rising population, without an inflation adjustment, without deflation for transfer payments, deficit spending, mortgage forgiveness, and of course Fed bond-buying programs. It's astonishing, but those are the nominal growth numbers.
Downturns in net corporate cash flows haves sometimes been associated with the advent of recession, but they have correlated well with a period of declining interest rates.
Commodity prices continue in downtrends, and the declines in sensitive commodity prices such as copper and oil are notable.
In addition, much of Europe is in deflation. Japan continues to see deflating consumer prices; China has powerful deflationary pressures stemming in part from a large number of non-performing loans.
All these, plus the oil and gas fracking revolution, plus the winding down of the war in Afghanistan, are disinflationary or deflationary phenomenon. The massive level of underemployment in this country ensures restrained wage growth in the aggregate.
The technicals support these fundamental trends.
Technicals: The five- and one-year charts of the 10-year bond look fine technically. If they depicted stocks in a downtrend, it's hard to look at these and say they were poised to start shooting up:
|Compare:||^TNX vs. S&P 500 Nasdaq Dow|
|Compare:||^TNX vs. S&P 500 Nasdaq Dow|
The five-year chart shows a pattern of lower highs and lower lows. These lows have been seasonal, and given the seasonal rallies the stock market has had every year since 2010, there's no obvious reason to reject the possibility that bond yields will again follow the pattern they have also been following since 2010.
Sentiment in Barron's Big Money Poll has, I believe, uniformly been bearish on bonds the entire period of declining long-term rates. For example, the April 2012 poll forecast a sharply rising 10-year T-bond rate for October 2012 of between 2.5-3%. This was the Barron's description of their views:
Bonds are another matter, however. Eighty-one percent of our respondents are bearish on Treasuries after a multi-decade bull market, and few are bullish on fixed-income assets of any stripe, including corporate and municipal bonds. The Big Money managers expect investors to shift gradually out of bonds, with 10-year-Treasury yields backing up to 2.5% to 3% in six months from last week's 1.970%.
As it happened, bond yields fell to about 1.72% six months later. An investor who wished to go against the consensus and simply purchased the Nuveen Insured Municipal Opportunity Fund (NIO) when the poll was taken would have had a price gain six months later of about 7%, plus about 3% in tax-exempt income already in his/her pocket. That would have handily beaten the six-month return from stocks.
That said, let's see what Barron's experts said about bonds two weeks ago in this year's spring survey, titled Dow 16,000!
Per the second table in their article, and assuming that the 10-year T-bond rate was around 1.9% when responses were received, it appears that about 91% of respondents were bearish on interest rates for the next six months. 92% said that T-bonds were overvalued. Virtually none thought they were undervalued. Presumably few Japanese money managers who were polled in 2004, during Japan's fifth year of a zero interest rate policy, believed that their very low bond yields represented undervaluation either, yet here they are with yet lower yields.
In other words, the technical and sentiment in April 2013 is similar to that of spring 2010, spring 2011 and spring 2012. While interest rates are lower, so is inflation, and the economic cycle is much more mature; and much of Europe is mired in a deflationary, 1930s-style depression. Given the move in stocks over those years, they are arguably also less attractive than they were; at least that's the view of "quants" such as Jeremy Grantham of GMO.
Thus it's unclear why the continued Federal Reserve policy of buying and hoarding massive amounts of Treasury and other bonds will suddenly make speculators and investors dump them. This might of course happen, but I find no technical evidence to suggest that the trend has changed.
Commentary: It is now almost exactly 32 years since long-term interest rates peaked. Total returns from stocks and bonds have been eerily similar in that period. This is true on time periods going back to the 1990s. It is also true going back to the ending month of the Great Recession, June 2009. (Note that I use zero-coupon bonds for comparison, as they are truer interest rate vehicles than par bonds.
The mechanism of Federal financing is via sales of bonds. Given the actions of the Feds to save the banks following the collapse of Lehman and other banks in 2008, the economy clearly is acting differently from the way we were used to it acting in the post-recession periods in the past three decades. Something broke and broke badly in 2008. A very low interest period appears reasonably likely to me as part of the healing process. Such an environment persisted for 20 years after the stock market bottomed in 1932. As late the recession year of 1958, the financial journalist James Grant documents a brief bond-buying frenzy that pushed rates to wildly low levels; such was the fear even then of another deflationary depression.
Just as deflation was the fear a quarter century after the Crash ended in 1933, today's fear is of a return of high inflation and surging interest rates. However, the desire that was nearly universal as late as 1958 to simply be sure of return of principal is one that motivates everyone my age (late middle age) and older. After all, the difference between a 3% interest rate on a 10-year muni bond and a 1.5% rate is not all that great. In the first case, for every $100 put into the bond, $130 comes back 10 years later. In the second case, $115 comes back. It's not that big a deal, especially since the percentage difference between the two is much less than the average 30+% drop in a typical recessionary bear market for stocks. It's further not a big deal if gasoline prices are declining, as they are now.
The supply of bond buyers at even lower interest could surprise many.
So could the possible emergence of a truer "bond bubble" than what is seen today:
The amazing stock run of 1995-99 may parallel a further surge higher in bond prices, should interest rates drop much lower. By 1994, many traditional measures of corporate stock valuations looked stretched. Only then did the best of the bull market get going. By the end of 1997, stocks had risen at least 20% in price for three straight years, tying a record set in the late 1920s. That parallel scared not a few people. 1998 was another 20%+ up year as well, despite a late summer-fall scare related to the Russian hyperinflation and the resultant fallout in the US financial community. Certainly that was enough for stocks, many thought. But of course in 1999, the Nasdaq went up 99%, and the broad averages had their 5th consecutive 20%+ up year.
There is a big difference, though, between that bull market and the ongoing bond bull. The average investor in that bubble era told pollsters that they were expecting 15-20% annual total returns from stocks in the future. Exuberance was everywhere. In contrast, the ongoing structural bull market in bonds is both hated and ignored. The most obvious reason it is hated is that everyone knows exactly what one will receive if one buys a very high quality 10-year bond at the end of 10 years. The result pleases few.
If one wants to assume 5-12% per year from stocks, one will shun bonds. But if one fears near-zero bank rates year after year as in Japan, one will not be upset with something above zero that allows a do-over at the end of the bond term.
On the very long end of the bond spectrum, there is minimal non-callable debt issuance other than from the Treasury. Thus, very long-term noncallable Treasury debt has a scarcity value, especially as the Federal deficit diminishes and the Federal Reserve holds onto its massive bond holdings. The Japanese have until recently been highly skeptical of their 30-year government bonds, and as a consequence the persistence of their bond bull market has made 30-year Japanese government bonds optimal total return vehicles for Japanese investors and savers.
Given the above points, a risk-taker may want to invest/speculate in long-term Treasury bonds, both for the modest income and for the chance that yields at least equal their repeated lows just under 2.50%.
I was schooled in finance in part on Wall Street Week and in Barron's by Martin Zweig (RIP). If one wants to go both with the Fed and with the trend, one may wish to suspend disbelief and buy what the Fed is buying: United States Treasury bonds. At the very least, if one is an American, it's a patriotic activity. At the very best, inflation will settle at a very low level for a sustained period of time, and it could be either a good trading vehicle and/or a good total return vehicle. In either case, it provides a counterpoint to many other investments, and thus can also be useful as a portfolio diversifier.
While individually-owned bonds avoid fund charges, if one is looking to trade them easily and efficiently, the funds mentioned early in this article all have adequate liquidity, though only TLT is suitable for day trading.
These are strange, unusual uncertain times in the investment world. It's my hope that the above thoughts at least provide food for thought, however your investments may be positioned.
Additional disclosure: I am not an investment adviser. Nothing herein constitutes investment advice.