U.S. Long Bonds: Buyer Beware

Includes: AGG
by: Prieur du Plessis

Bill Gross is buying them after misreading the market last year, while the Fed is buying them in their operation TWIST. The bull run is supported by the perceived safe-haven qualities of U.S. bonds, especially in the current weak patch in global growth and the crisis in Europe that is culminating in the degrading of sovereign bonds. The stronger U.S. dollar is also an added attraction. On the other hand, Warren Buffett and some prominent commentators, this blog included, have been warning against the bubble in U.S. bonds since 2009. Yes, we nay-sayers have missed an incredible bull market in U.S. bonds over the past 18 months. Have we been wrong about the underlying fundamental value of U.S. long bonds?

Well, the yield on the 10-year government note is nearly 2% below the CPI inflation rate and recently dropped below the core inflation rate for the first time in 32 years.

Sources: FRED; I-Net Bridge; Plexus Holdings.

The circumstances 32 years ago were vastly different compared to today, though. At that stage the core CPI inflation rate was more than 13% while the yield on the 10-year note ranged around 12%. You had the prospect of solid returns if the inflation rate returned to the pre-oil crisis levels.

This time around bonds are pricing in an extended period of deflationary depression. The extent to which the valuation of U.S. bonds is out of sync with the U.S. economy is best illustrated in the graph below in which the yield on the 10-year government note is depicted against the Conference Board Consumer Confidence Index. The relationship indicates that U.S. bonds are priced for consumer confidence falling to approximately 10. That compares to the worst level ever of 25 in the first quarter of 2009 amid the great 2008/2009 crisis.

In normal circumstances the yield on the 10-year note would be closer to 3% or 100 basis points higher than currently.

The U.S. economy is slowly but steadily turning for the better. The improved employment situation supported by rising unit labor costs is pushing the core inflation rate higher.

Sources: FRED; I-Net Bridge; Plexus Holdings.

Holders of U.S. long bonds are therefore faced with a conundrum. If the core inflation rate continues to rise while the yields on the long bonds remain unchanged due to the Fed’s actions, the gap between long bond rates and the core inflation rate will open up even more. Long bonds will therefore become even more expensive. When will this period of irrational exuberance end?

At their most recent meeting, most members of the Fed’s policy-making committee agreed that slow growth was not reason enough to expand the Fed’s economic aid program. With incoming positive economic data the chances of QE3 in the next few months are diminishing fast. Where will the demand for longer-dated bonds come from if the Fed stops buying?

Amid the current rather lethargic growth in the U.S. economy there are clear signs that investors are already increasing the risk assets in their funds. Against the background of negative real returns of U.S. longer-dated bonds any sustainable acceleration in economic growth is likely to switch away from bonds.

However, in the short term bonds are likely to benefit from lower CPI inflation rates as my leading indicator, the absolute change in oil prices from a year ago, is pointing to the U.S. CPI ex shelter declining to between 2 and 2.5% in February/March.

Sources: FRED; I-Net Bridge; Plexus Holdings.

In my opinion, it is therefore not a question of if the bond bubble will burst, but when!