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Summary

  • Historic bond bull market Lives, with important implications for all investors.
  • 30-year Treasury bond nears golden cross.
  • Implications for stocks are short-term neutral, intermediate-term negative.

Background: Except for Operation Twist in 2011-2012, the Fed is not said to target the rate for the 30-year Treasury bond. Thus, excessive ease on the short end of the yield curve, which the Fed targets and to a large extent controls, should be reflected if anything by higher interest rates at the long (free market) end of the yield curve. This was seen in June of 2003, when the Greenspan Fed put in one last Fed funds rate cut as "insurance," upon which the long bond sold off furiously. What we then saw was the Fed removing accommodation by raising the Fed funds rate by 1/4% at every FOMC meeting, accompanied by the failure of long-term interest rates to rise much. Then-Chairman Greenspan bemoaned the seeming paradox of the flattening yield curve by calling it a "conundrum," especially as sensitive inflation indicators such as crude oil and gold were rising rapidly in price in 2006-8, but as we have seen, the bond traders had it right. Powerful deflationary/disinflationary forces were at work, and the business expansion was founded on such ephemera as a housing bubble.

With the repeated immense stimulus provided by the Fed following the collapse of Lehman Brothers and the sluggish business expansion following the end of the Great Recession in 2009, received wisdom has been that the Greenspan conundrum is over and done with: long-term interest rates are "too low" and are destined to follow the same rising path they took in the latter part of the 1950s for years to come. However...

Action in the bond market recently has been powerful enough to challenge that view. The breakout in yields of last spring and summer has given way to a resumption of the structural bull market in bond prices (i.e., decline in interest rates) that began in and around 1981. This article discusses certain features of the structure of interest rates and concludes that as in the prior cycle, powerful deflationary/disinflationary forces are at work. In a sense, the current set-up involves the sum of all bubbles. The Fed is close to being "all in." How many more stimulatory moves can it, and the Federal government, have left if growth/nominal GDP fail to accelerate?

Introduction: A long-term view of the 30-year Treasury shows the current action well, followed by a shorter view, from Yahoo! Finance (adjust time frame to suit, using Interactive tool for custom views). The reasonable steady, relentless downtrend remains in place:

Chart forTreasury Yield 30 Years (^TYX)

Chart forTreasury Yield 30 Years (^TYX)

(Ignore the vertical bars at the bottom of the first graph.)

Technical note: The above were drawn with the y-axis on a geometric scale, but it is not clear that interest rates should receive that treatment. The charts look somewhat different when shown with the y-axis on an arithmetic scale.

With the 2-year T-note only yielding 34 basis points (0.34%), positive carry of some importance is gained from the 10-30 bond. Put another way, the annual dividend yield on the S&P 500 is 1.90%. The 2-10 yield spread is greater than that dividend yield. Both the S&P dividend yield and the 2-10 yield spread are thin pickings to investors, but the case can be made to go for the 10-year bond over stocks or over the 2-year note.

My interpretation of the above is that one economic cycle evolves from the prior, with crucial lessons and analogies. Both the post-2001 recession period (with stock crash) and Great Recession and recovery period were marked by bursting investment bubbles and supportive Federal Reserve and Federal government policy (monetary and fiscal policy were both loose). In each case, policy-makers were surprised by the extent of deflationary pressures but after long periods of growth, rising interest rates and bull market action in stocks, they withdrew stimulus. This was marked in and around 2006 by shrinkage of the Federal deficit to around 2% of GDP, similar to the current trajectory, and continued rises in the Fed funds rate, which nonetheless lagged the rate of inflation. The analogy now is of course the "taper" of quantitative easing. Investors must judge whether withdrawal of stimulus (i.e., "taper") in the setting of a weak economic expansion is similar in effect to the interest rate rises between 2004-6 in the setting of a strong, inflation-riddled economic expansion.

I think the case that there are similarities is not unreasonable.

Under this analogy, the sharp drop in long-term interest rates from about 5.5% in 2004-5 into a peak of 5.25% in 2006 is similar to the 2011-12 drop into the peak in 2013. In each case, the peak rate was lower than the prior peak. Spurred by transitory headline news out of the Ukraine, which "should" have little effect on the proper interest rate going out 30 years, we now see the 30-year rate repeatedly drop below the 200 day moving average (using exponential moving averages). That this has occurred for the longest duration of the Treasury complex, but has not quite done so for the benchmark 10-year suggests that smart money wants to own this very long term bond.

Furthermore, this has happened while minor increases in a number of short-term rates have occurred. Thus, the yield curve has tightened a bit. If Ukraine were the problem, traders and hot foreign money would want to hide in the short-duration paper, not the risky and relatively illiquid 30-year bond.

The implications of this trend, if validated, appear as follows. The 4% testing area of several years ago for the 10-year bond have given way to a 3% testing area, and so far that has held. The next tests would be back at 2% and then the all-time lows around 1.5%. For the long bond, the 5% area of 2007 would now have given way to a 4% ceiling, and a quick look at the chart suggests that 3% is the next target. It is at 3% that some battle occurred in 2009 after the post-Lehman panic interest rate lows, and 3% again was a battleground in 2011 when rates crashed following problems in Europe, the U.S. debt downgrades by S&P and others, and the impasse over raising the Federal debt limit. Precedent from the past 30+ years of declining long-term rates supports this 3% target. Of course, true bond bulls look to target the all-time low 2.5% (approximate) yield on the 30-year bond, with the next target an amazing 2% (I'm not holding my breath for that, but it's a possibility).

Analogy to Japan: From Kshitij, a consultant to forex and other traders, I have lifted these charts:

What is fascinating is the gravitational pull, as it were, that the zero bound of short-term rates exerted on long rates as Japan sank toward zero or negative inflation (it depends how and when inflation in Japan is measured). Japan went to near-ZIRP (zero interest rate policy) in 1998 and official ZIRP early in the millennium. The U.S. went to near-ZIRP after the tech wreck, was unable to sustain a return to normal rates (which were still at or below the inflation rate even at 5%), and went to ZIRP in late 2008. As with Japan, almost every surge in rates was to lower highs. This pattern continues to occur in the U.S., as the interest rate surge last summer has topped and may be rolling over once again.

There simply may be something "real" about the existence of zero interest rates at the short end, both in the case of Japan, where inflation has been net zero or marginally negative for over a decade, or the U.S. where inflation has been positive but low.

Demographic reasons for deflation: It is no coincidence that Japan and several European countries that have deflation also have low birth rates and fertility rates well below 2.0 children per woman of childbearing age. The U.S. has a near-record low fertility rate, as well, and demographics here show an aging population that will not vote for an inflationary program.

Futures markets indicators: The 10-year bond is showing a pattern of speculator positioning that has resulted in bullish action for the bond over the past 5-6 years. Here is the FINIVIZ graph showing commercial hedgers in the 10-year in green and small and large speculators in blue and red, respectively. We are now seeing speculators increasingly fight the minor uptrend in bond prices (decline in rates). When this has occurred in the past 5 years, they have been wrong:

This chart and prior history cannot be used to prove what will happen next, but I like the set-up. Sentiment on interest rates is almost universally bearish, expecting higher rates. So the speculators are reflecting conventional wisdom. The pattern of the rising green line, which rose again during very recent bond strength, was seen during generally bullish periods in 2008- summer 2010, again in 2011, and more briefly in 2012 as rates went to cyclical lows.

With that pattern of growing speculators bearishness and commercial hedger offsetting bullish being seen again, the open-minded trader and investor must wonder if the current economic expansion is getting tired. Is it 2005-6 again? 2007?

Interest rates might rally for fundamental reasons: Here are several reasons bonds might rally (i.e., interest rates decline).

1. Stocks are poor competition. John Hussman and Jeremy Grantham (firewall) each estimate approximately zero nominal total returns from U.S. stocks over the next seven years. If a growing number of people believe this, and/or if equity results begin to act as if those quantitative projections will be accurate, then the equilibrium yield for a 7-year Treasury note will be about zero, with very low, Japanese-style yields anticipated for the 10-year in that case.

In other words, very high equity markets could spur even higher bond prices.

2. The bearish view of the past half-year of employment reports propounded by Dr. Ed Lazear could gain sway.

3. The recent downtrend in retail sales, which is approaching recessionary year-on-year levels, could signal recession. Per Doug Short:

(click to enlarge)

This trend suggests that interest rates could descend back toward lows seen in 2012-13.

4. Global slack is suggested by the following chart from ECRI, which is privy to data on the many commodities not traded on exchanges by virtue of its partnership with the Journal of Commerce:

ECRI's conclusion is:

Thus, the mounting deflation in world trade prices is signaling growing slack in the global economy.

In other words, ECRI is saying that investors should (or should have) buy (bought) Treasuries.

5. A commodity sensitive to domestic economic conditions is lumber. Lumber prices are far below their levels of one year ago, from Random Lengths:

This Week
Mar 14
Last Week
Mar 7
Year Ago
2013
Random Lengths Framing Lumber Composite Price*$387$388$432
KD Western S-P-F #2&Btr 2x4 R/L Mill Price368363408
KD Eastern S-P-F #1&2 2x4 R/L, delivered Great Lakes451445498
Green Douglas Fir Std&Btr 2x4 R/L (Portland)375390385
Southern Pine (Westside) #2 2x4 R/L417419468
KD Coast Hem-Fir #2&Btr 2x4 R/L405405435
Ponderosa Pine (Inland) #2&Btr 1x12 R/L735745615
* Weighted average of 15 key items

Random Lengths Framing Lumber Composite Graph

A sharp drop-off is also seen for structural panels (oriented stranded board, OSB):

This Week
Mar 14
Last Week
Mar 7
Year Ago
2013
Random Lengths Framing Lumber Composite Price*$387$388$432
KD Western S-P-F #2&Btr 2x4 R/L Mill Price368363408
KD Eastern S-P-F #1&2 2x4 R/L, delivered Great Lakes451445498
Green Douglas Fir Std&Btr 2x4 R/L (Portland)375390385
Southern Pine (Westside) #2 2x4 R/L417419468
KD Coast Hem-Fir #2&Btr 2x4 R/L405405435
Ponderosa Pine (Inland) #2&Btr 1x12 R/L735745615
* Weighted average of 15 key items

Random Lengths Framing Lumber Composite Graph

6. We know what's happening with "Dr. Copper"; here's the current trend for the global crude oil benchmark, Brent crude:

The price trend has been down, despite tensions between western Europe and Russia over Ukraine.

7. The partial resumption of the Cold War tends to make people think of U.S. government bonds. One never knows when a real crisis will occur.

How to invest in bonds: Because spreads are so low and savers can buy treasuries so many ways, there is no incentive for brokers to push Treasuries. Retail investors can buy and even trade individual bonds; bid-ask spreads are very low. Most investors who buy Treasuries buy traditional coupon bonds that pay interest twice a year. Somewhat higher yields are generally available from zero coupon (or STRIPS) bonds that pay no current interest. These are bought at a discount and mature at par at a date certain. The government taxes the yearly imputed but unpaid interest, however; these bonds are best suited for tax-deferred accounts such as IRAs.

Most investors who buy Treasuries likely to so through funds of various sorts. Adventuresome investors who want to express a point of view that rates are headed for a meaningful drop can amplify gains by purchasing long term bonds. In the U.S., the default ETF for this is the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT). Even more venturesome investors can purchase ETFs that own nothing but long-term zero coupon Treasuries. One is the Vanguard Extended Duration Treasury Index ETF (NYSEARCA:EDV), which is commission-free for Vanguard clients. The other is the PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA:ZROZ). Both EDV and ZROZ pay income on gains as they are able.

Summary: To general disbelief, not only is ZIRP in effect so many years after Lehman Brothers collapsed, but as in Japan in its ongoing ZIRP period, the downtrend in long duration interest rates remains in effect. Multiple fundamental, technical and contrarian factors exist to justify this downtrend. The 30-year Treasury interest rate is nearing a golden cross using exponential moving averages. In any case, it is acting as it has to one degree or another in every business expansion since the 1982 recession ended, namely continuing the downtrend that began with the 1981 peak in interest rates.

Aggressive investors may wish to consider investing in TLT; more aggressive strategies could include purchase of EDV or ZROZ, or of individual zero coupon bonds of long duration.

Investors will, of course, realize that locking in a guaranteed sub-4% yield for as long as 30 years may carry an opportunity cost versus equities, even if one accepts the arguments of such experts as Jeremy Grantham and John Hussman that prospective total returns from U.S. equities look bleak for the next 7-10 years.

Conclusion: Both as a portfolio diversifier and as an aggressive long strategy, investors and speculators may wish to consider the possibility that the amazing bull market in bonds may have a good deal more life left and thus may merit either a trading position (not necessarily after the recent run-up) or a core position for long-term investment.

Source: Turning Bullish On Bonds

Additional disclosure: Not investment advice. I am not an investment adviser.