Moving Towards Higher Interest Rates and Downgrades

Includes: TLT
by: Disruptive Investor
In his monumental work The History of Interest Rates, Sidney Homer brings to light the secular bull and bear markets for government bonds. Very similar to commodity and equity bull and bear markets, bonds as an asset class experience secular long-term cycles. Understanding this is of paramount importance today, when the bond market is experiencing a transformation from a long bull market to an expected long-term bear market.
In relation to this, rising interest rates, weak economic activity and continued government spending (in my opinion) will also bring forward an era of rating downgrades for the American bond markets. Before discussing further the current scenario, I would like to bring to light the secular market cycles in the twentieth century. From 1899-1920, the American bond market experienced a phase of gradually increasing yields (bear market). The reversal in 1920 brought forward 26 years of bull market, which culminated in 1946. Thereafter, bond yields again started to trend upwards, peaking out in September 1981 (with 10-year bond yields surging to 15.32%). The period of 1981-2009 saw declining yields and another long bull market for American bonds.

The chart below shows two such cycles (bull and bear markets).

[Click to enlarge]

As mentioned above, in my opinion interest rates are headed higher from the lowest levels the bond yields reached (post the collapse of Lehmann Brothers). There are several reasons for this point of view, which will lead to much higher interest rates in the next decade and further.

Before talking about some of the key factors that will push yields higher, I would like to mention that real interest rates might still remain negative or zero, even in high interest rate scenario. In other words, high interest rates would be accompanied by significantly higher inflation.

Here are some of the key reasons for predicting the beginning of another long-term bear market for American bonds.

  • There is a very high probability of key rating agencies downgrading U.S. debt. This will have an immediate incremental impact on the bond yields considered as one of the safest investments in the world.
  • One of the largest buyers of Treasury bonds, China, is experiencing inflation of over 6%. There would be no incentive for the government to buy Treasury bonds yielding 3-4%. A relative decline in demand for bonds would automatically push yields higher.
  • the U.S. economy is showing clear signs of slowdown. In such a scenario, the policymakers would surely step in with further stimulus. More stimuli not only reduce the credibility of the previous actions of the policymakers, but also increase local and global inflation (as more money flows into industrial commodities and energy). These factors are perfect for yields to move higher.
  • Commodities experienced a bear market from 1980-2000. Post that, commodities have been on an upside mainly supported by incremental demand from China and India. With huge impending growth in both these countries, commodity prices are expected to remain high over long-term. Therefore, just from demand perspective, commodities should continue to trend higher. This would necessitate investment in higher returns yielding investments by both India and China.
  • The stimulus packages in the past have only been able to revive the economy in the short-term. The deficit reduction plan might not work at all if the economic growth remains sluggish. On the contrary, deficits might trend up if the policymakers embark on further stimulus. This will negatively impact bond yields over the long-term.
  • Several emerging market government bonds and corporate bonds are yielding higher returns and are relatively lesser riskier than Treasury bonds. This opens up new avenues for investment for governments having surplus funds.

Hence, in my opinion, Treasury bonds can be considered for short-term investment when sentiments are over bearish. Long-term investment in treasury bonds might not be the best investment option in the current scenario.

If one believes that interest rates are going to trend higher from these levels, the probability of witnessing series of downgrades on American bonds is something very likely over the next decade. The process has already begun with Chinese rating agency Dagong deciding to downgrade the local and foreign currency rating of the U.S. from A+ to A with a negative outlook. There is a high probability that S&P and Moody’s might also follow the same line of action in the next six months.

Of course, the story does not end here. As interest rates move higher, so will the debt servicing cost. With a weak economy and further stimulus expectations, there is no doubt that we will see a stage where more debt is required just to service existing debt obligations. Therefore, in my opinion, we will witness an era of frequent debt downgrade for the bond market accompanied by higher inflation and higher interest rates.

From an investment perspective, cash and treasury bonds might be one of the worst long-term investments. Precious metals, industrial commodities, agricultural commodities are themes which look interesting for a long-term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.