Long The Long Bond Is Still A Good Trade

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by: Joachim Globell

Summary

Historical real long bond yields are mean reverting to around 2%.

The unproductive use of new debt is slowing the velocity of money and thus putting downward pressure on the inflation rate.

In a zero inflation or disinflationary scenario, the long bond yield can go to below 1%.

Following the turmoil of the British vote to leave the European Union, there are now $11.7 trillion worth of bonds with negative yields. According to a Fitch Ratings report, that's a 12.5 percent increase since the end of May and up a whopping 67% since mid-February.

What's more, the holders of such bonds are willing to hang onto them for even longer, which Fitch said was the biggest factor in the increase. The total of negative-yielding debt with maturities of seven years or longer has swelled to $2.6 trillion, nearly double the amount in April.

Further, the entire Swiss yield curve is now negatively yielding.

Japan is negative out to 17 years.

German 10s are -12 bps.

The US 30yr is yielding in the context a massive 2.2%. The lowest in a few hundred years give or take. So are treasuries still a worthwhile investment going forward?

To get some perspective on this, let us take a step back and start with the basics.

The Fisher equation states that the Treasury bond yield is equal to the real rate plus expected inflation.

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Looking at the real rate over time, it is extremely volatile and thus impossible to predict. However, over a longer time period, this can be worked around as the long-term real rate is mean reverting to around 2% as can be seen in the graph.

In a low growth environment, due to over indebtedness, aging demographics, populism and geopolitical instability, in addition to the difficulty forecasting the real rate and its mean reverting properties, the main factor to determine the long-term movements in the Treasury bond yield is the inflation/deflation story. Inflation is typically described as a persistent increase in the general price level, such as in the consumer price index. This view can also be represented by the so-called "quantity theory of money," which relates the general price level, the total goods and services produced in a given period, the total money supply and the speed (velocity) at which money circulates in the economy in facilitating transactions in the following equation:

MV = PQ

In this equation:

  • M stands for money.
  • V stands for the velocity of money (or the rate at which people spend money).
  • P stands for the general price level.
  • Q stands for the quantity of goods and services produced.

As stated by the equation of exchange, total liquidity has two sub components. One is quantity of money or money supply. Quantity is highly complex to identify, but reasonably easy for the policy makers to manipulate. The below graph illustrates the remarkable increase in money quantity by China and the US during and following the financial crisis.

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The other component is the velocity of money or money demand.

The velocity of money has been falling around the world since the late 90s.

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Velocity is also highly complex and has a very large number of input factors, but two stand out as most important. First, productivity of debt. If the new debt issued generates the income enough income to repay interest and principal, then velocity will be stable or rise; however, if it doesn't, the velocity is declining. The more unproductive the debt becomes, the greater the risk of velocity declining.

Looking at the below graph of US debt to GDP ratio, one can infer what is happening to the productivity of debt.

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In this artificially low rate environment that we find ourselves in, new debt is clearly being skewed toward unproductive activities, and not being invested in sufficiently income producing assets.

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Change in debt per $ of GDP:

Period

$ of Debt/$ of GDP

1952 - 1999

$1.7

2000 - 2014

$3.3

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Last year, debt increased by $1.9 trillion with GDP only increasing $0.5 trillion; a ratio of $3.5, showing that this trend is accelerating.

And second is the private sector's dramatic increase in their willingness to hoard money instead of spending it. The saving rate in the US as an example is up 50% since pre-2008 as savers realize the lower the interest they get on their deposits, the more they have to save. Such an unprecedented increase in money demand has also slowed down the velocity of money.

Unless countered by an increase in the quantity of money, this slowdown in velocity will lead to deflation. Arguably the V-shaped recovery experienced in 2008-9 was due to the massive increase in quantity mainly by China and the US. Remember China took its central bank assets from $8-$10 trillion pre-crisis to close to $35 trillion in 2014. Since then total assets have started to come back down, the same holds for the US as the Fed started its tapering in the fall of that very year.

So what is the probability that the Fed will get back into more QE to try and stave off the fall in velocity? Very high, I would argue. As I am writing this, there are rumors of Japan being on the verge of helicopter money, a mere six months after introducing negative rates. In addition, Fed governor Loretta Mester, in a speech in Australia, argued for the same here in the US. However, I strongly believe as Irving Fisher lays out in his paper from 1933, "The Debt-Deflation Theory of Great Depressions", that when economies become extremely overly indebted, then central banks can no longer control rate of growth of money or the velocity of money. So unless we start issuing productive debt again and the savings rate drastically falls, neither of which I see happening in a ZIRP/NIRP world, I believe there is a high probability that we will get to a zero inflation or even disinflationary stage with the CPI at negative 50 maybe even 100 bps and thus with a long-term average real rate of 2%, nominal rates can on the 30-year bond easily go to 1%-1.5%.

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.