How To Position For The 'Most Expensive Bond Market In History'

by: Armchair Quarterback


We face a situation in which some say the 30+ year bond market rally is close to an end, we disagree.

We believe current slow growth conditions will remain for years to come.

We believe a diversified portfolio of fixed income and credit securities matched with appropriate duration and funding structures will outperform most asset classes, including equity and real estate.

Stepping back from the day-to-day commentary by pundits on the direction and timing of FOMC rate hikes; and the daily fluctuations of the Brexit polls; and the latest fed funds futures probability forecasts, we decided to put the current economic and monetary conditions into a longer term context.

Yields on 10 year US treasury bonds have fallen from approximately 16% in the early 1980s to currently below to 2%.

Below: a graph of the 10 year US Treasury yield since 1965 showing the yields peaking in 1981 and falling steadily to current levels.

10 yr US Treasury yield since 1965 Click to enlarge

We face a situation in which some say the 30+ year bond market rally is close to an end. Years of non-traditional monetary policy have distorted the financial system and will lead to unintended consequences.

We disagree that the bond market rally has come to an end.

We believe current slow growth conditions will remain for years to come; we will experience continued disappointments in the effectiveness of monetary policy; additional rounds of non-traditional easing will need to be implemented; and persistent deflation and under-utilization of productive human resources will cause societal and cultural aggravation.

Incorporating the above views into an investment strategy we believe yields on treasury securities will remain low and believe a diversified portfolio of fixed income and credit securities matched with appropriate duration and funding structures will outperform most asset classes and certainly offer a compelling risk reward result.

With this in mind, we are nevertheless vigilant and cautious of unintended consequences brought about by a prolonged period of non-traditional monetary measures. At this time, we see no evidence that would cause us to modify our strategy or cause us concern.

The 10 year US Treasury peaked at close to 16% in 1981. Paul Volcker took over as the Chairman of the Federal Reserve in 1979 determined to eliminate inflation and restore monetary stability. Fed funds rates were raised to a peak of 20% in June 1981 causing a massive adjustment. By the mid-1980s, economic growth was restored and interest rates began their 30+ year march downward. Ben Bernanke was appointed as the Chairman of the Federal Reserve in 2006. Having written and lectured on the causes of the Great Depression, he brought with him an academic framework citing tight monetary policy as prolonging and deepening the negative effects of the economic malaise. He initiated drastic and extraordinary measures during the global financial crisis of 2008 including bringing the fed funds rate to zero and directly injecting funds into the financial system and buying assets. Since then, we have seen 10 year US Treasury yields slide to levels below 2%. The aftermath of the crisis and the policies implemented have yet to be resolved.

We've endured months if not years of back and forth speculation about the path, timing and magnitude of normalizing interest rates and unwinding super-easy monetary policy.

Below we show a graph of the implied probability of Fed rate hikes as determined by prices on the Fed Funds Futures contracts for the December 2016 meeting. You can see the red line crosses the olive-green line 7 times in the past six months meaning the implied probability changed as many times from a likely hike to no change.

Fed Funds Futures Implied Probabilities Click to enlarge

[Source: Bloomberg]

This uncertainty regarding short-term rates and the constantly sputtering recovery has created a chorus of cautionary proclamations. All with long term yields grinding lower at every reset. It's gotten to a point where predictions of an eminent collapse of another financial bubble now regularly permeate the media channels.

Below we highlight some of the quotes we've seen just in the past couple of days:

This is the "most expensive bond market in history;" From Bloomberg, "Jack Malvey went back as far as 1871 and couldn't find a time when global yields were even close to today's lows." Also from Bloomberg, "Bill Gross went further tweeting they're now the lowest in 500 years of recorded history;" The reporter for the Bloomberg article concluded that "whatever the case may be one thing is clear, there's never been a bond market quite like this one."

Other quotes from various popular media articles include, we are experiencing "unsustainably low yields"; we are experiencing a "bond market bubble."

We can't match the research resources of the Federal Reserve Bank, or Pimco or Allianz Global, and with the surface-level searched that we have conducted; we cannot dispute some of the factual statements above. So, we'll accept other people's propositions that we are at historically low yield levels.

Despite this realization, we don't believe that we are at risk of a sharp reversal or on the verge of a bust of a bubble in the bond market. We agree that there are opposing forces creating an unsustainable situation. So we ask, how do these forces resolve themselves?

In asking the following questions, we will seek to generate a list of possible scenarios that markets, asset prices and interest rates could take and we'll generate tactical positioning ideas for our portfolios.

Question 1: Is the US economy finally recovering from the financial crisis of 2008 and are we on a path to "normalization?"

Below we show two graphs that show a similar theme with a subtle difference: Unemployment vs (1) Industrial Production and vs (2) Capacity Utilization

Both graphs show very clearly robust economic conditions just prior to the financial crisis and the trauma caused during the crisis and the steady improvement in economic conditions ever since. The subtle difference between the two, industrial production seems to stay high whereas capacity utilization seems to be sliding.

Unemployment vs Ind Production Click to enlarge

Capacity utilization below showing slowing momentum.

Unemployment vs Capacity Utilization Click to enlarge

From an economic perspective, we believe the above graphs along with:

Real GDP yoy growth running at an anemic yet positive rate of over 2.0% since March 2014 ;

Personal Consumption qoq growth straddling the +2.0% rate since 2010;

Unemployment rate falling steadily from a peak of 10% in 2009 to currently below 5%;

ISM Manufacturing Index staying above 50 since mid-2009 except for 3 out of the ordinary months;

Conference Board of US Leading Index of Ten Economic Indicators rising consistently, reaching a high of 123.9 from a low 90.94 in Feb 2009;

Other data are stable to positive including Housing Starts, Retail Sales, and Consumer Confidence.

So, we would argue that the economy is recovering, ever so slowly and moderately and however lackluster it may feel.

Question 2: Are we really deleveraging?

The following graphs show that aggregate liabilities are increasing in both the corporate and household sectors.

Corp vs Household Debt Click to enlarge

Looking at the Federal government balance sheet reveals the same picture, debt is increasing not decreasing.

Household vs Federal Debt Click to enlarge

Federal Debt as a Percentage of GDP Click to enlarge

One visible sign of de-leveraging is the graph showing household debt as a percentage of GDP falling from a high near 98% to a level around 80%.

Household Debt as Percentage of GDP Click to enlarge

Summary, there is a sign of deleveraging and perhaps we could find more. But this has to be one of the shallowest deleveraging cycles on record coming after a severe financial markets crisis.

Question 3: Has the Fed begun to unwind super-easy policy and how far do they have to go to "normalize?"

This is just the beginning of the unwinding of the Fed's super-easy monetary policy. This graph shows how much they need to unwind and how one might infer how long it will take.

Fed Assets vs Fed Funds Rate Click to enlarge

Question 4: Is monetary policy working? Or is it pushing on a string?

Rising velocity of money = economic growth; Falling velocity = economic stagnation or contraction; Currently no signs of a change in velocity upward….Velocity of M2 continues to fall feeding deflationary forces regardless of easy monetary policy and low long term interest rates, i.e. monetary policy and low interest rates are not transmitting through to the real economy and stimulating activity.

Velocity of M2 vs 10 year CMT Click to enlarge

Question 5: When was the last time anyone was really concerned about inflation?

CPI since 1963 Click to enlarge

Question 6: Is the US stock market getting "toppy?"

Below, we've shown a picture for graphic representation. We could look at PE multiples, dividend yield, equity risk premia, sector rotation and a number of other measures and we would find enough warning signs for us to justify our cautious stance.

10 yr UST Yield vs Wilshire 5000 Click to enlarge

Summarizing our conclusions we get the following list of potential scenarios:

(1) Sharp rise in interest rates, (yield curve shifts up) - HIGHLY UNLIKELY

(2) Continued soft economic data but the Fed hikes so the curve flattens, maybe inverts setting up for the next recession - SOMEWHAT POSSIBLE

(3) Shock to the system - Brexit; China economic and or a market disruption; Geopolitical turmoil; Natural disaster; Terrorist attack; Trump presidency - HARD TO POSITION FOR,… BUT OUR STRATEGY SHOULD MANAGE MOST SCENARIOS

(4) Unintended consequences - We've heard of and read some extreme scenarios, but it's hard to put our arms on what could / might happen that is completely unexpected - THESE ARE LOW PROBABILITY SCEANRIOS BUT THE MOST DIFFICULT TO POSITION FOR OR MANAGE THROUGH

As we've said, we are cautious on the U.S. stock market and would reduce our allocation.

We are not overly worried about scenarios that drastically change the current interest rate environment and thus would position for a diversified portfolio of fixed income and credit products with a moderate to longer duration preference supplemented with funding structures that generate yield and carry.

We believe that if properly structured, these portfolios will outperform equity and real assets.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.