The Treasury yield curve continues to flatten (Chart 1), suggesting either that the bond market is pricing in a recession, or that the bond market's fears about deflation and low growth have gone to a nearly unprecedented extreme. The last time rates were about this low was in 1946, just after World War II, when interest rates were still capped by the US Treasury to help the government finance the war (Chart 2). Given recent events like Brexit, there is an element of a flight-to-safety trade present in the current bond rally for US investors, and there is a yield-chasing element present for foreign investors. Indeed, a whole range of countries, including Denmark, Sweden, Switzerland, the ECB, and Japan have negative rates for major parts of their yield curves (Chart 3), which provides a powerful incentive for yield-chasing investors to buy US treasuries, driving their yields even lower.
Chart 1: Long Term Downtrend for 10-Yr. Yields
Chart 2: The Last Time Rates Were So Low Was Just After World War II
Source: buckley.whotrades.com; wsj.com
Chart 3: Huge Expansion of NIRP Around the World
Source: tinyletter.com; wsj.com
There is no particular reason to believe that this downward trend in yields is likely to end anytime soon. Although certain economic data are deteriorating (e.g., industrial production), overall data are mixed and a recession, although more likely than a year ago, is hardly anyone's base case scenario at present. This leaves us (for now) with the worldwide deflationary trend, the fear of a European banking crisis and/or a Chinese currency devaluation, and the global debt overhang's impacts on growth, as our primary drivers of the observed flattening of the yield curve in the US (Chart 4), and the negative yields in a number of other countries. If we examine the likely track for the long bond yield based on the historical tracks of previous episodes involving the aftermaths of balance sheet recessions (Chart 5), it is clear that much lower yields are not only possible, but highly likely. There have been very strong arguments presented on this score by economists like Lacy Hunt, Gary Shilling, and John Mauldin.
Chart 4: Flattening of US Yield Curve Over the Last 2 ½ Years
Chart 5: Long-Term Declining Yields After Market Panics
Source: Lacy Hunt; hoisingtonmgt.com
Economist and fund manager John Hussman has written frequently ( www.hussmanfunds.com) about the liquidity preference curve (Chart 6), which indicates that investors will likely chase yields on all competing assets down towards the near-zero yields now existing on 3-month T-Bills. They will do this with risk assets like junk bonds and stocks, as long as they are willing to take risk. When they stop wanting to take risk (i.e., when they fear the next bear market), they will perversely want to hold cash above all things, since there will be little difference in expected returns between cash and risk assets. This is the primary result of years on end of financial repression by the Fed, and it's also the result of the never-ending European crisis. But my question is, what will happen to investors if we follow this probable declining yield track?
Chart 6: Liquidity Preference Curve
Source: John Hussman; hussmanfunds.com
It seems to me that investors will see the already terrible prospective returns from balanced portfolios get even worse, as I have discussed previously. But if long bond yields continue downward to the eventual vicinity of zero for the 10-yr., or under 2.00% for the 30-yr., then asset allocation models as we know them will be inoperable. There are then two ways to approach the asset allocation problem: 1) through the application of relevant theory; and/or 2) through the use of practical extrapolations from historical precedents. With regard to theory, the only one I know of that's relevant is the idea of cash preference that was just discussed above. That would suggest that cash will be king at some point. However, there are some historical precedents to examine that may give us an idea of what investors may actually do when the yield curve has flattened almost to a null reading on long bonds, AND risk is perceived to be unacceptable for all risk assets like junk bonds and stocks.
For example, author Russell Napier has written extensively about what happened to various asset classes in the Great Depression (cf. Napier, 2007; Anatomy of the Bear: Lessons from Wall Street's Four Great Bottoms, 2 nd Edition, Harriman House Ltd., Peterfield, Great Britain, 304p). Obviously, stocks sold off catastrophically, but the more interesting asset classes are investment grade corporate and government bonds. Government bonds initially rallied during the period from September 1929 to June 1931. However, once the banking crisis began and the government abandoned the gold standard (note that the modern day equivalent would be the disbanding of the Eurozone), government bonds actually sold off. Bonds finally stabilized once the Reconstruction Finance Corporation was established in January 1932 (Chart 7). Investment grade corporate bonds sold off massively after September 1929, but then recovered and made great gains side-by-side with government bonds from 1932 onwards. Stocks also bottomed in the summer of 1932, rallying strongly until the second dip of the Great Depression began in August of 1937.
Chart 7: Government Bond Prices in the Early Great Depression
Chart 8: IG Corporates and Govt. Bonds Rallied Strongly After 1932
Source: dentresearch.com; economyandmarkets.com
Analyst Sivaram Velauthapillai wrote in a 2009 posting that the Japanese deflationary bust from 1990 to 2008 was a good model for evaluating how bonds should perform in long lasting deflationary environments like the present one. He pointed out that the initial bottom for long government bond yields was around 1% (Chart 9), although since he wrote his analysis, JGBs have dropped into negative territory (Chart 10). Given this history, the already low yields on US Treasuries do not preclude making significant total returns from them in the months ahead. The US 10-Yr. Treasury closed at 1.387% on July 7 th, 2016, so there may be as much as another 1.00-1.37% left to go before the bond rally is exhausted. For the long end of the curve then, significant gains can still be made, assuming that the long-term trend continues.
Chart 9: Implied Yields on JGBs from 1991 to 2012
Chart 10: JGB Yield Curve Comparison, Jan.-Mar. 2016
Using the examples from the US bond market in the Great Depression and the Japanese bond market in their "great deflation," we can see a way to handle asset allocation if current trends continue. Since we know that historical examples of extended yield declines are associated with major equity sell-offs, we would want to minimize our equity risk exposure. We would also want to expand our bond exposure, primarily on the long end of the treasury curve. Thus, we would simply use liquid alternatives on the equity side of portfolios, together with dividend growth funds, and long Treasury bonds on the bond side of the portfolio, with plenty of cash as a buffer.
Trades of interest in this environment would include the purchase of long treasuries (Vanguard Extended Duration Treasury Bond ETF (NYSEARCA:EDV), Vanguard Long Term Government Bond ETF (NASDAQ:VGLT), I-Shares 20+ Yr. Treasury Bond ETF (NYSEARCA:TLT), and Vanguard Intermediate Term Bond Fund (NYSEARCA:BIV)), defensive dividend growth funds (SPDR S & P High Yield Dividend Aristocrat ETF (NYSEARCA:SDY)), liquid alternatives (Otter Creek Prof. Managed Portfolio (MUTF:OTCRX), AQR Long/Short Fund (MUTF:QLENX), and AQR Equity Market Neutral Fund (MUTF:QMNIX)), and sophisticated hedge-like strategies (Nuveen S & P 500 Buy-Write Income Fund (NYSE:BXMX)).
Disclosure: I am/we are long SDY, OTCRX, QLENX, QMNIX, BXMX, TLT, BIV.
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: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.