This article represents a shift of some importance back to beating the drums for the world's most important financial asset other than cash itself, namely US Treasury bonds.
This comes as Bloomberg News reports:
Government bonds retreated in Europe and Asia after comments by Federal Reserve Chair Janet Yellen fueled concern that policy makers will tolerate faster inflation. Global shares declined...
Even as the outlook for inflation picks up, central bank policy makers have reiterated commitments to keep stoking prices to spur economic growth. Bank of England Governor Mark Carney said last week that he'll tolerate an inflation-target overshoot, with Yellen echoing that sentiment, saying there are "plausible ways" that running the economy hot for a while could repair some damage caused to growth during the recession...
"The Fed, in allowing inflation to run above target, may be changing the game in rates," said Peter Chatwell, head of rates strategy at Mizuho International Plc in London. "We finally have a fundamental reason for long-term yields to push higher and for inflation premia to re-rate."
Note: the above link was good; on editing this a couple of hours later, I see that it now links to an update, in which Bloomberg notes that Treasuries are (were) up in price, down in yield. Interesting how online news changes...
Here's why I would trade against this view, which I see as slightly better than propaganda, but not much better.
Background - why bonds when central banks (allegedly) want higher inflation?
I have been one of the Internet's biggest bond bulls since Q2 of 2011, usually favoring Treasuries but favoring munis when they out-yielded Treasuries by late Q3 of 2011 for a year or two; and pointing out how very cheap high grade junk bonds (NYSEARCA:HYG) were last December.
There was a period after Fed chairman Bernanke unexpectedly extended QE 3 where stocks were my favorite asset class; this extended to the end of 2014, at which time Seeking Alpha published a year-end interview with me and titled it "DoctoRx Positions For 2015: I Have Cut Back On My Exposure To All Biotech Substantially."
The bond bias ended at different times this year, when rates fell to extreme levels in the 10-30 maturity range, and to a lesser degree as short as the 5-year range.
Thus I've been saying for a while that excess cash reserves made sense to let some asset class or another both drop in price and gain some fundamental speed.
Little did I know as recently as last week that my choice was going to be certain Treasuries, and as soon as now.
Just a personal note: I'm basically a retiree who does not alter asset allocation a lot, so these articles do not necessarily reflect a churning, heavily traded account for myself or the family accounts I manage (at no charge). However, some readers are money managers looking for independent ideas; most of you are individuals who may either have excess cash reserves, be looking to reduce exposure to an asset class, or may happily be in a cash flow positive state so that you are in general looking for new ideas for free cash. That's the spirit in which these articles are written.
Here's what's changed both fundamentally and technically for bonds just in the past few days.
Chinese yuan sets multi-year lows: historically bond-bullish
When an exporter's currency declines 5% in a year versus the USD, that country can see a 2% inflation rate internally while we in the US see a 3% deflation rate, both on our imports from the country and in our exports to it. That's what's been going on for two years between the US and China, though for most of that time, manufactured goods in China have seen deflation even in renminbi terms.
The USD/CNY dollar-yuan cross has ratcheted higher once again, reflecting depreciation of the yuan. This ratio is 6.73-6.74 as I write this Monday morning. It is up from 6.34 one year ago, representing 5% depreciation of the yuan versus the USD. It is up from 6.11 two years ago, basically a 10% appreciation of the USD. If you think that it's a coincidence that the relative changes are the same over one year and two years, then there's the famous bridge between Manhattan and Brooklyn to consider purchasing. The Chinese have been managing this decline, but for one reason or another, it's been occurring in jumps, and going back two years, these jumps to new highs in the ratio, now at levels last seen in 2010, have correlated with peaks in interest rates in the US. For example, the last breakout came this past May. Then, the plain vanilla 7-10 year iShares T-bond fund (NYSEARCA:IEF) jumped 4% in price, a big move for it, and did so quickly. The much more volatile 20-30 year iShares T-bond fund (NYSEARCA:TLT) went from under $130 on May 18 to above $143 on July 8, a very stock-like move.
With TLT back under $132 and IEF also back near its April-May lows, but with the USD even higher against the yuan, there is ample fundamental room by this metric for longer-term US rates to decline. This would allow a corresponding price rise in these bond funds, or in the individual bonds.
Dr. Copper enters a downtrend
This has interrelated fundamental and technical aspects, because my sense is that at least to a degree, futures trading in copper tracks fundamentals rather than just being speculative or heavily manipulated, as I believe certain other futures markets are. Thus the deflationary price action of copper once again suggests that the advent of sustained higher expected inflation may once again be premature.
Tying in to the yuan depreciation, again gradually, mainstream analysis is finally catching on to the concept I've been propounding as a pro-bond reason for years: China's economy hasn't really been "growing" at 7% a year for quite a long time. After all, "investing" in wasted additional heavy industry capacity is an old strategy, a.k.a. mistake, of Communist governments. So "growth" = waste.
Thus we see Reuters reporting Monday that:
China's economic growth is expected to cool to 6.6 percent this year and slow further to 6.5 percent in 2017, even as the government keeps up policy support to help ward off a sharper slowdown, a Reuters poll showed.
Now, with slow or even zero working age population growth and productivity gains now limited, the chance that China's economy can grow in real terms anywhere close to 6.6% is approximately zero, especially net of negative growth as excess capacity in multiple industries gets closed. It's a game they play, and it allows this gradual depreciation of the yuan as well as continued real and absolute price declines of the commodities China used to import with such zeal.
So, with copper having taken a large, sudden hit late last week, it now looks to have peaked near $2.22 to below $2.11 today. This has harmed a potentially bullish formation of a higher low, but now we have a lower high. In addition, speculator sentiment among large traders in copper is as bullish as it has been in years, which has been a reliable bearish signal (red line in the bottom panel in the weekly FINVIZ chart below):
So this fits technically with the increased signs of a top in rates, at least a tradeable one.
Oil and other metals
Spot oil has rebounded, but oil in the out years has been flat as can be. Crude for 2024 delivery remained under $59 per barrel even as spot crude exceeded $50. I have taken this as reasonably bullish for inflation, and have ignored the bean-counters who warn that lapping YoY price declines in oil means that "inflation" is returning. That's much too obvious and formulaic to accept. Curve flattening means much more.
All the above is consistent with the quiet bear market into which platinum (NYSEARCA:PPLT) has fallen. Platinum recently had a spike peak to $1200/ounce, but has now fallen more than 20% to around $930. From FINVIZ (daily chart):
Spec positioning is no longer bearish (to a contrarian); this may be a bottom; but platinum is much rarer than gold and traditionally is more expensive than gold.
Silver and palladium (NYSEARCA:PALL) are in approximately 15% corrections, also challenging gold's still-bullish price chart.
The price action of copper, oil and platinum et al. continue to raise the question of whether gold is "on to something" or is ready to surprise most observers and take a dive. I'm standing clear of a directional position on any of these commodities given all the cross-currents and foresee many possibilities. The only certainties are brokerage, storage costs and no interest income.
Now to bonds themselves.
Bond technicals strengthen week on week
While it's insufficient to buy any commodity just because of prior chart and positioning patterns, in order to actually like the bullish case, it's important to me to have the technicals and fundamentals aligned. So I liked it, as primarily a bond investor these days, that the large speculators, who have been pretty reliable contrary indicators on Treasuries for years, increased their bearishness on bonds, continuing to go more all-in on the rising inflation, rising oil price, rising shorter-term interest rate bets. They are now bearish on the 2-, 5- and 10-year Treasuries and only marginally bullish on the 30-year; the latter position being a bet on curve flattening as the Fed allegedly ramps up a new tightening cycle. My guess is that this cycle never comes, though it may tighten in December.
Here are the daily charts showing the changes in positioning of the 2, 5 and 10's (click on each maturity at the above link for detailed views). Note, the least volatile 2-year is close to flat, but that's also a recent change for the better for us contrarians:
Now, the 5-year shows the biggest change and is the safest investment in my humble opinion (discussion below):
The speculators have really ramped up their bets on significant interest rate increases even though rates have already risen from a low of 0.92% to nearly 1.3%. The specs have also finally turned net bearish on the 10-year, which is important to me:
The above positioning changes by the specs is pure trend-following combined with following central banker rhetoric. Why these traders let central bankers manipulate their financial bets as they do is beyond explanation. These bankers will say one thing one week and then the exact opposite the next.
Overall, I take this as bullish for lower rates for a while. Combined with the evidence from the USD/CNY, metals and oil, and no special strength in US economic data, I'm liking bonds again, especially in the 5-year maturity range where the specs are most bearish.
In contrast, the 30-year Treasury has a relatively narrow spread over the 10-year and still some speculator bullishness. I'm actually long some long bonds, but for income only. If long rates drop, great; if not, I plan to just hold.
Investing in bonds
As I try to remember to note in the disclosures for every article, I am not a financial adviser and do not provide financial advice. That noted, the two main concepts I want to discuss relate to bond ownership via funds versus individual bond ownership, and comparing Treasuries to corporates.
Funds versus individual bonds
Overall, as an older saver/investor with enough wealth to diversify and hold long-term bonds to maturity, in practical terms, I prefer to pay one commission one time to acquire a bond and then let it roll along, rarely thinking about it. There's enough to think about in this world! If I want to sell it, fine, but if the bond is high quality, then I'm guaranteed a positive return at a date certain.
Whereas, with a fund, it's possible to imagine many years in which rates rise fast enough so that the net asset value of the fund depreciates by at least as much as the interest payout; so that the investor may end up with no nominal return for years. In addition, presumably some degree of inflation will occur, giving a loss in real terms.
The main advantage of a fund if dealing with bonds one can acquire on one's own, such as Treasuries or liquid corporates, is that one can flip it. So if one likes 5-year Treasuries and wants to play "small ball," one can buy the iShares 3-7 year Treasury ETF (NYSEARCA:IEI), get a small monthly income, and then if rates drop enough, trade out of it for a (very modest) capital gain. But maybe stocks or gold will have dropped at the same time, making for a nice sequential set of trades. More income, more risk or chance for a tad more capital appreciation comes with longer durations; IEF and TLT provide progressively more return and price volatility with great liquidity. The individual trader cannot come close to the ability to trade these by owning individual bonds, even heavily traded Treasuries.
One final weakness of ETFs is that in a selling panic, which can happen to bonds, the funds will be forced to dump inventory when prices are down, and that forced selling will force prices even lower. Whereas, individually-owned bonds can just be held through the storm.
Treasuries versus corporates
The more experienced (older!) I get, the less I think of the old "Fed model." This compares yields on Treasury bonds with earnings yields (reciprocal of the P/E) on the stock market (NYSEARCA:SPY).
But that's comparing like to unlike. Better to think of corporate bonds, which yield more than Treasuries but are intrinsically higher quality than the common stock, and compare them with stocks. In that situation, a higher quality well known corporate bond fund (NYSEARCA:LQD) has been trading around a yield to maturity of 3%. That's with a much shorter duration than stocks. If rates rise, over time the yield on the fund will rise as well as older bonds mature or are called and are replaced with bonds at current, higher interest rates. If rates fall, the fund will allow capital gains if the investor comes to prefer a different asset.
A lower quality asset is HYG, the higher grade junk bond fund that has pretty good credit quality. This yields much more than the SPY both on current yield and yield to maturity and is in my opinion an interesting alternative to the stock market for retirees and pre-retirees (and maybe for all investors willing to take on extra risk).
Whereas, Treasuries have more capital gains potential in a crisis and greater liquidity at all times than even a corporate bond fund. I am pretty conservative when it comes to bonds, but in our IRAs, I did some trading several months ago when Treasury yields were so low and replaced some of them with very high-grade corporates, such as the non-callable AAA-rated bonds of J&J (NYSE:JNJ). There was a nice little yield pick-up, and if over time somehow the US interest rate structure surprises almost everyone and "goes German or Japanese," then corporates have farther in yield to fall than Treasuries, thus may have greater total return potential (yield plus capital gains potential). But the reason to do the trade is for increased yield with virtually no extra credit risk.
One of the reasons I write about bonds as much as I do is that increasingly, the financial wealth of the US and the richer countries is concentrated in retirees and pre-retirees, including pension funds. It's my further observation amongst my peers, i.e. Baby Boomers, that the older we get, the less inclined we are to speculate while dreaming dreams of achieving a lot of wealth by picking a hot stock or two. In contrast, safety and security come to the fore with provision for adequate income. And as we have seen in other regions, the lower interest rates go, the more capital has to go to fixed income to achieve the same income level. The theory of rising dividends beating stocks has not yet met with popular approval. As shown above, one reason is that corporate bonds provide higher current income than the SPY, and the SPY yields more than the total US stock market (WIFVX). Plus, corporate bonds yield more than the SPY with less credit risk and with shorter duration. So over time, I expect financial advisers and maybe even the financial "news" networks to undergo a certain shift to where more and more of their viewers are - or would be if they offered relevant information and analysis.
Beyond all the above points, I want to reiterate the yet bigger picture I've been perceiving. This is my view that the US is experiencing fairly typical late cycle markets and a late cycle economy, full of potential whipsaws and changing trends: the most difficult markets I know of.
As we move into full-on earnings season, I do not expect to write another macro article of this nature for some time. If anything major changes in my outlook, I will try to get an InstaBlog out on it.
Thanks for reading; all comments are appreciated.
Disclosure: I am/we are long IEF,TLT,LQD.
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: Not investment advice. I am not an investment adviser.