These days it seems market commentary is filled with more conflict than consensus. Even the most grizzled market veterans acknowledge that these are the most challenging market conditions they’ve ever faced. I suppose it makes sense then, that some of the most knowledgeable and experienced experts on the street are presenting coherent but completely disparate arguments on the future direction of just about every tradable entity under the sun. Bonds – the traditional safe haven – are no different.
Many say that the bond market is much smarter than the stock market in reflecting and predicting economic activity and asset prices. Yet the market sages seem to differ dramatically on the direction of the bond market as well. Let’s take a look at two very well-presented theses on the fate of bonds. One says buy long term bonds and the other says sell.
“. . . the quarter end 2.75% yield on long-term U.S. Treasury bonds may, in the future, look as attractive as the 5% yields registered back in 2007.”
~ Hoisington Investment Management
In their Q2 Review and Outlook (courtesy of John Mauldin’s Outside the Box) Dr. Lacy Hunt and Van Hoisington of Hoisington Investment Management made the case for still lower bond yields in spite of the fact that many thought we would never see the 30-year treasury yield hit the depths it recently plumbed. Their thesis is based on both economic growth and government debt levels. It draws on three recent research papers as well as three historical references: the debt-induced panic years of 1873 and 1929 in the U.S. and 1989 in Japan.
Most of us are aware that interest rates (bond yields) have a rather intimate relationship with economic (GDP) growth that goes something like this:
The guys at Hoisington acknowledge all of the above, but note that extended periods of excessive debt (relative to GDP) can exert prolonged downward pressure on interest rates due to a variety of factors:
- If “this debt is utilized for either counterproductive or unproductive investments” aggregate demand would suffer, causing bond yields to remain depressed.
- “If the effects of excessive indebtedness (low growth and low interest rates) are addressed by additional debt, or by debt utilized for investments that cannot produce an income stream to repay the obligations, then this even higher level of debt will serve to perpetuate the period of slow economic growth and unusually low bond yields.”
In each of the three periods of excessive debt referenced (1873, 1929, and 1989) too much credit was made available, bubbles formed, and liquidity crises ensued when they inevitably popped. The parallels between these debt crises and the bursting of the U.S. housing bubble are not lost on these authors. In each of these cases, bond yields remained depressed, with average yields remaining around 2.5%. As we all know, JGB yields remain extremely low 23 years (and counting!) after the Japanese debt panic of 1989.
Many are waiting for the bond market to signal that government debt levels are too high by sending bond prices down and yields higher. These authors say that by the time that happens (if it happens at all), the damage to the economy will already have been done via depressed GDP growth. They think we have quite a few more years of low and falling interest rates. They say bonds are still a buy here.
I thought the Hoisington piece made a good case for buying or sticking with bonds for a few more years – until I read Doug Kass’ side of the story. Not only is he not buying long term bonds, he thinks that bonds are the short of the next decade. He cites 7 key factors that could be disruptive to the bond market:
- Flight to safety premium erodes
- Muddle through economy gains steam
- Fed policy on hold – leads to natural price discovery
- Inflation on ascent
- Housing recovering
- Stocks vs bond approaching reallocation trade
- U.S. fiscal imbalances are not being addressed
Overall, it seems Mr. Kass does not believe that the economy will remain weak much longer, and that should lead to a massive reallocation out of bonds and into stocks. Bonds have been in a bull market for over 30 years and he’s thinking a mean reversion trade is in the offing. Makes sense right? No trend lasts forever.
After reading both of these fine pieces, I’m sure many an average investor might be thoroughly confused. I know I was, so I’ll try to work through some of my current thinking on all of this with the hope that it might help you figure out where you stand as well. In short, I tend to side with Hoisington on the factors affecting bonds over the next decade, but like Mr. Kass, I have no desire to buy bonds. (I wouldn’t short them either, however.
I know that probably sounds even more confusing, so give me a moment to explain where I’m coming from with a few bullet points of my own:
- The economy will likely remain sluggish for the next decade or so, or until the debt overhang improves. This is mainly due to the effects of excessive debt mentioned in the Hoisington research. I have no idea how long this deleveraging might take. If Hoisington is right, we’ll be waiting for a while. If Mr. Kass is right, the economy will improve a lot sooner than I think.
- As long as GDP remains anaemic, bond yields will likely remain low. But . . .
- The bond bull market is long enough in the tooth that I still don’t care to be involved. I’m not sure when it will turn, but I’m happy to get 1% – 3% return from my GIC ladder with no capital risk in the interim. Whenever bond yields begin to rise again, GIC rates will rise with them, and I won’t have to worry about capital losses from falling bond prices.
No one ever said investing was a game of absolutes. It’s full of nuance and uncertainty. I know that many will simply stick to their preset stock/bond allocation and re-balance as needed. I’m not saying that’s a bad plan either, but this is how I’m balancing the uncertainties of the bond market for now.