What About Bonds?

by: Eric Parnell, CFA


New Fed sheriffs are coming to town.

Their arrival is expected to bring higher interest rates from the U.S. Federal Reserve.

What should we really expect for the bond market going forward?

New Fed sheriffs are coming to town. And their arrival is expected to bring higher interest rates from the U.S. Federal Reserve. While many have concluded that this, along with increased inflation expectations, will bring the 35-year bull market in bonds to an end. But while it's easy to declare that the bubble in bonds is going to burst - the investment highway is lined with many experts that have made this bold call over the past three and a half decades - what should we really expect for the bond market going forward?

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A Dubious Contraction

It is a point that usually goes unchecked in the financial media but warrants further discussion. The airwaves and print are filled with analysts and experts making the following claim: "the bull market in stocks will continue while the bond bubble is about to burst". Perhaps this will come to pass, but such conclusions are not so easily drawn.

First, stocks (NYSEARCA:DIA) and bonds (NYSEARCA:BND) do not exist in a vacuum. The last I checked when doing basic fundamental discounted cash flow analysis, the interest rates that are derived from the bond market play an important part in determining the intrinsic value of a company. And when interest rates are rising, it results in lower intrinsic values for stock prices all else held equal. Thus, if the bond bubble is about to "burst" as some analysts claim, this implies sharply and sustainably higher interest rates going forward, which of course implies meaningfully lower intrinsic values for stock prices all else held equal. Of course, not all else is held equal, and what is required to overcome the negative force of meaningfully higher interest rates is meaningfully stronger growth. But such growth may prove elusive if the cost of debt is soaring and sales demand is suffering as a result of these same higher interest rates. Moreover, it is not as though stocks are starting from a position of strength heading into any future spike in interest rates with stock price valuations already at historical highs.

So perhaps these pundits will be proven correct and we will see a bursting of the bond bubble accompanied by a still stampeding stock market. But it will be a very fine needle that must be threaded in order to achieve such a rosy outcome.

What About Bonds?

But what about the conclusion that the bond market is going to burst, if not simply struggle, over the coming years in what could potentially be a rising interest rate environment marked by strong growth and rising inflationary pressures? Is this even the right conclusion? Or could bond investors reasonably expect a somewhat better outcome?

Let's begin with the following important point. Bonds have one distinct advantage over stocks that often gets ignored. Rising interest rates from the U.S. Federal Reserve usually lead to recessions. In fact, nine out of the last ten times that the Fed entered into a sustainably rising interest rate phase, a U.S. economic recession eventually followed. The only exception was the soft landing in the mid-1990s that came at the start of the technology fueled boom that followed through the remainder of the decade.

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Now when the U.S. economy goes into recession, stocks typically perform poorly due to the associated decline in sales and earnings. At the same time, bonds in general (NYSEARCA:AGG) and U.S. Treasuries (NYSEARCA:TLT) in particular perform well as investors rotate from the relative risk of stocks to the relative safety of high quality bonds.

So unless this time is going to be different, which given the eventual demise of nearly every investor that has uttered this phrase has proven suggests that it is not, we should reasonably expect that any future sustainable rise in interest rates will ultimately be bad for stocks and good for bonds like Treasuries, and not the other way around.

But what about long-term bonds in particular? Won't the rise in the fed funds rate naturally put long-term bonds under heavy pressure along the way until the economy finally hits up against the rocks? Once again, not necessarily if history is any guide.

Let's consider the last time that the U.S. Federal Reserve raised interest rates. During this period from June 30, 2004 to June 29, 2006, the U.S. Federal Reserve raised its target fed funds rate from 1% to 5.25%. Such is the style of interest rate normalization that many speculate about today, although any such normalization today would likely lead to a target fed funds rate toward the 3% range instead.

The increase in the fed funds rate had a profound impact on the short end of the U.S. Treasury yield curve as would be expected. For example, the yield on the 3-month Treasury bill (NYSEARCA:BIL) started the interest rate hiking cycle at 1.33% and ended it at 5.01%. Such dramatic moves higher in rates were seen moving out the Treasury yield curve toward the 5-year maturity range. But toward the middle of the curve in the 7-year to 10-year maturity range, these upward influences started to level out. And from 10 years and beyond, the cumulative change in interest rates over the two-year time period from 2004 to 2006 was virtually none.

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What is more notable is the path that the yield curve took along the way from June 2004 to June 2006 when the Fed was regularly raising interest rates. During most of this time, the yield curve did not move up but effectively pivoted, with interest rates associated with maturities of 5 years or less moving higher while yields for Treasuries beyond the 5 year remained consistently lower. This is represented in the chart below by the addition of the yield curve from early September 2005. In fact, it was not until the last few months of the Fed's rate hike cycle in 2006 when long bond yields finally headed back higher, but only to where they started in June 2004.

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What explained the resilience of the long end of the Treasury curve during this extended time period? The Fed through the target fed funds rate influences the short end of the yield curve. But these effects do not necessarily feed through to the long end of the curve, as additional considerations such as the expectations for a recession at some point in the near-term future will induce investors to hold on to their income producing securities that are backed by the full faith and credit of the U.S. government for a measure of safety against this expected future outcome.

With all of this in mind, the environment was actually quite constructive for bond investors for most of this time period from 2004 to 2006 despite the fact that the Fed was raising interest rates steadily over this entire time period.

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What About Bonds Today?

But what about bonds today? Aren't conditions much more challenging for the bond market today than they were over a decade ago?

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What about the massive deficits and increase in debt levels under a Trump administration? First, I'll believe these future deficits and debts when I see them, but it's not as though we didn't see the national debt explode from $10 trillion to $19 trillion under the Obama administration, yet Treasury yields moved steadily lower throughout his tenure.

But what about the fact that the Fed will be raising rates along with this increase in the debt? Sure, but it should be noted that the national debt increased by +16%, or $1.2 trillion, from $7.3 trillion to $8.5 trillion under the George W. Bush administration during this period from 2004 to 2006 when the Fed was raising interest rates, yet long-term U.S. Treasuries (NYSEARCA:IEF) did quite well. And one has to look no further than Japan to see that a government can absolutely explode the balance on its national credit card and have sovereign bond yields that do nothing other than go lower.

But what about the explosion in inflation that is supposed to accompany the increase in debt spending? Once again, I'll believe these inflation pressures when I actually see them, but its worth noting that the 10-year breakeven inflation rate today at 1.89% is still meaningfully below the 2.25% to 2.75% range that persisted throughout the rate hiking cycle from 2004 to 2006. In short, concerns about inflation were even greater then than they are today, yet long-term Treasury bonds did quite well.

But what about the economic expansion that is coming with the pro-growth policies under the new administration? Broken record - believe 'em when I see 'em - but it should be noted that the U.S. economy was steadily expanding between a 2.5% and 5.0% rate on a real GDP basis throughout this entire Fed rate hike cycle from 2004 to 2006, yet long-term U.S. Treasuries performed quite well.

But what about the fact that U.S. Treasury yields are so low today? OK, but the same could be said about historical high P/E ratios on the stocks in the S&P 500 Index (NYSEARCA:SPY), so in a certain respect they cancel each other out on a relative basis. Moreover, while the U.S. stock market has the relative disadvantage of being one of the most expensive stock markets in the entire world, the U.S. Treasury market has the relative advantage of looking like a complete and total bargain with yield premiums that are among the highest in recent history relative to the likes of its global safe haven peers in Japan and Germany.

The Bottom Line

So while the experts spew the notion that all will be rosy for stocks and dismal for bonds going forward, mine is a different take. I expect bonds, particularly U.S. Treasuries will hold up surprisingly well, while the stock market as a whole may struggle for an extended spell starting at some point in the near future. Perhaps I will be wrong - only time will tell - but I like my odds on this bet given the historical precedence.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I am/we are long TLT,IEF.

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

Additional disclosure: I am long selected individual stocks. I also hold a meaningful allocation to cash at the present time.