Further Points On The Bond Bull-Bear Fight (Part 2 Of 3)

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Summary

In this second part of a three-part series, a focus on demographics as a possible driver of continued low interest rates is presented.

The possibility of "good deflation" in energy production, manufactured goods and other things is also discussed.

The historic tendency of low interest rates to take their time bottoming and turning up is discussed.

If we are entering such a period, the phenomenon of rolling down the yield curve may be of interest and is also discussed.

This article therefore serves as a bridge between the first article and the conclusion, which focused on specific investment strategies and tactics.

Background

In Part 1 of this series, I laid out the backdrop for my continuous focus on interest rates as part of the key to investing. This has served me well in mostly achieving and sometimes exceeding my financial goals since my first stock trade in 1979, even during the 18 years (1982-2000) when it was all stocks, all the time for me, with little interest in bonds until the bubble years in the late '90s.

The main points in that article a "don't fight the Fed" focus, noting also that the commercial banking system was functioning well, but combining the credit creation coming from banks with the negative credit creation stemming from the Fed's reversal of QE had led to stagnation in "thin air" credit. This trend is bond-friendly. Since the Fed and broad credit creation have driven markets for years, I made that the focus of the article.

One of the secondary points I made was that if we rather arbitrarily look at Treasury bond yields since the end of the Civil War era, say when Multpl.com begins its data presentation (around 1871), a "normal" bond yield has been 4%. From that perspective, the era of "low" Treasury yields only began in 2010. In contrast, the era of "high" yields ranged from the early 1960s until 2010.

So, maybe there are decades to go of "low" yields to offset the decades of "high" yields?

This article explores the demographic, geopolitical and financial factors that may produce that result. The final article is focused on investments rather than this bond bull versus bear discussion.

Given all the uncertainties, this is not my highest conviction thesis; and it's definitely not a timing one. What puts me more on the side of the bond bulls is the historical tendency of low interest rates to bottom over a period of years. Right now, it seems as though almost everyone is waiting for the inflation monster to return, and that makes me think the crowd could again be too early. Even a stable rate structure could be good for bondholders at a time when stocks are highly valued and cash yields so little.

I'll begin with the most important factor I think favors bonds, demographics.

Demographics and the economics of aging favor conservatism

Likely we all know about extremely low fertility rates, population growth rates, and high rates of growth of the elderly population, especially the "old old" above age 80 or so. This is moderately disinflationary, but this story is well known. Thus I'll focus on some different though related matters that are more specific to investments.

In contrast to the go-go '60s, when there were numerous pressures on capital markets, demographics point the other way now. The cycle, as it were, really relates to the 1920s and beyond. But for simplicity, I'll begin with the Baby Boom. This surprised people when it occurred, and it paused during the period of rationing during the Korean War, but it put inexorable pressure on the physical layout of the U.S. Schools needed to be built, then colleges and universities; then homes. The '70s saw massive homebuilding, and it was no bubble. As all this was coming to a boil in the late 1960s, given that the Baby Boom lasted from about 1947-63, advances in medicine and growing real wealth creation meant that for the first time ever, people need not work until they either expired or became disabled. Retirement became part of life, and that required financing. Thus, Social Security became much more prominent in the nation's finances, and Medicare came into being with strong bipartisan support. Add in the Viet Nam War, and the Fed got called upon by presidents Johnson, Nixon and then Carter to deal with the unending demands for more and more credit.

It was only in retrospect that the pattern has emerged that demographics was the most enduring part of that up-cycle for inflation and rates. After all, the historically high interest rate of 9% was first seen in or around 1974, and that was the rate when 1979 began. It was also the rate that was seen in or around 1990. As rates began to decline after 1994, with the 10-year dropping near 4% in 1998, that was paralleled by the "greatest generation" retiring. And now we have the Baby Boom itself retiring. Since the peak of the Boom extended into the early 1960s, this wave will continue into the 2020s. It's only just getting started.

Could it be that along with the ups and downs of Fed policy, the economics of first the old-timers and then the Boomers has been the main surprise to consensus expectations, just providing the "under" that continues to deceive economists?

What are the investment economics of aging in US and the West?

Although senior citizens spend more on healthcare, or personal aids as needed, by and large, they (we, including myself) have diminished needs and a great ability to cut spending if needed. What that means is that investors, we oldsters are not too bent out of shape if we lose a little ground to inflation. Also, since most of us have one or more children, grandchildren, etc., a growing economy with some inflation, i.e. a 1990s sort of economy, means that our younger loved ones have good chances for success. So even if we do not directly participate in some additional financial upside via equities, that's OK.

So there are good reasons for retirees and near-retirees to be satisfied with greater security of principal than the young 'uns - all the way down to holding more permanent cash, which as regular readers will have noted, is an unusual favorite in the DoctoRx world.

All that maybe standard fare, but the problem is that most of the investment capital in the US is already held by retirees and near-retirees, and much of the rest is held by pension funds. So this situation is unlike the situation in the 1950s, when there were not a lot of retirees, and most of them were pretty poor and did not expect to live very long. Then, people like my father were the main savers in America, and being younger, were able to think very long term. Also, when they simply looked at dividend yields versus bond yields, look what they saw in December 1948, the year my parents got married:

  • 10 year T-bond: 2.3%
  • S&P 500 yield: 6.1%
  • S&P 500 P/E: 6.6X.

Then the bull market moved along. Taking the first-day-the-year P/Es of Dwight Eisenhower's term, from Jan. 1, 1953, through Jan. 1, 1957, the average P/E was 11.8X. The average dividend yield of the S&P 500 was 4.6%. Yet the 10-year T-bond still averaged less than 3%.

So where was the incentive for savers who wanted to leave the comfort and safety of insured bank deposits? It was to equities. And back then, there were something like 30 AAA-rated US companies, plus plenty with no debt and therefore no credit ratings at all (Now there are only two AAA-rated companies, and virtually no large ones with not enough debt to receive a credit rating).

So what will attract the growing legion of retirees and near-retirees to stocks versus bonds?

Most people with savings that they anticipate needing in their lifetimes (thus excluding the super-rich), but with enough wealth to invest in securities rather than just a CD, may have $100,000 or may have $1,000,000 (or more) in liquid assets. And most really, really don't want to manage the money. They just want it to manage itself. So, some will do a total market fund. But when others look into it, possibly with the help of a CFA or other advisor, they will find that blue chip exposure to the S&P 500 (NYSEARCA:SPY) will only give them an income of 2% a year unless they sell some of their principal; and that 2% per year will very likely grow at some rate consistent with the growth rate of the US and to some extent the global economies.

Let's take a mainstream view of reversion to the mean. That view might entail 6% dividend growth, reversion of S&P 500 operating margin growth from the current 10% to 8% (and some time below 8%), reversion of P/Es to the 14-15X range, and interest rates reverting upward. What you will find is the very real possibility of low-single-digit total returns over a 10+ year period, and possibly zero total returns; Jeremy Grantham has this in his seven-year projections (Obviously no CFA will swear to anything). This is not inspiring; people remember the dramatic crashes more than the longer but less flashy upswings.

However, a corporate bond ladder can be constructed or a fund purchased that provides a higher current yield and that will adjust upward to provide higher yields if yields trend higher, without loss of principal value. So one can get a higher yield, better quality securities, with shorter durations from corporate bonds (not Treasuries, though) than with corporate equity at current prices. I'll go into this in more detail in the final article of this series.

All this argues for more demand for corporate bonds than stocks from the aging demographic that in general wants current income and less exposure to duration than growth stock investors want.

While talking about corporate bonds, it makes sense to next briefly discuss international flows of funds.

What ex-US investors may like best about US investments

Leaving aside changes that have not yet occurred from the incoming administration, what's special about government bonds is that they can be monetized. So long as the monetizing authority is from a very strong government, its writ will hold; think Japan as an example. Thus, US government debt is always of interest to foreigners. I've been making the point for many months that given the yield differential between US bonds and those in the EU and Japan, there is a continual gravitational attraction to savers in those regions. Why this has persisted is unclear. If an investor had purchased a US Treasury at 2.33%, the current yield, within the past year or two, the positive return would have been the current yield, a small amount of appreciation as the bond "rolled down the yield curve," and the currency gain (see concluding remarks for a discussion of this phenomenon).

This arbitrage opportunity continues onward. There have been other times when the 10-year Treasury has yielded less than the 10-year German bund. Now the spread is a well-above average 200 basis points. That reversion to the mean, and even to no spread at all, could well occur in the next couple of years as the European Central Bank continues on its mad money-printing spree while the Fed may put a bit of the screws to the US economy. Their inflation rates may rise; ours may peak and fall.

So this is a continuing positive for US bonds, especially high-quality liquid ones that may be attractive to investors in the extremely low rate countries.

Technology may be creating "good deflation"

The business leaders who are saying positive things about increasing employment in the US are no dummies. They intend to use technology to operate cost competitively here.

One example involves Carrier, one of the major operating units of United Technologies (NYSE:UTX). When Carrier agreed to keep part of a plant in Indiana open, "saving" about 1,000 jobs, it also announced that it was going to undertake a significant automation effort at the plant. That's really the only way to make this effort work when it comes to manufacturing.

Of course, the US has the world's greatest collection of universities, high-level colleges and, broadly speaking, technology expertise. So, for example, when Bayer (OTCPK:BAYRY) promises to spend lots of money on R&D in the US as part of its deal to purchase Monsanto (NYSE:MON), it's playing to a different strength of the US.

The combination of advanced R&D and advanced production techniques is intensely deflationary, and in a good way. This trend, typified by the many deflationary benefits related to the Internet, can be better for bondholders than stockholders. The problem with less costly ways of producing goods and services goes beyond price cuts. It also relates to creative destruction of companies.

As an example, you might wish to price the return on bonds of Amazon.com (NASDAQ:AMZN). Even if the company succeeds big-time from year in turning into a profit machine, it's very plausible to think of the stock having EPS of $40 in 2027 and a P/E of 18X for a stock price of $720 never paying a dividend or spinning off a company. Whereas, you can get a nice little return from the bonds, which do not (yet) trade at the highest levels of credit quality. I favor AMZN bonds over the equity on any time frame beyond a few months.

Another area of potential deflation comes from energy production. Utility scale solar power is being delivered across the world fully cost competitive with coal, at prices around 3 cents/kw hour - unsubsidized. Further, I've been reading that horizontal and high-tech drilling techniques may bring US shale oil production to $30/barrel, assuming LNG can be created as well.

Energy might get cheap again due to technology.

As R&D gets better, as computers get better, as AI gets better, costs can be taken out of more and more production and distribution processes.

A "good deflation" in a number of products and intermediate products such as electricity and even fuel oil may await us.

Seasonality and other technicals

For traders, and even long-term investors looking for an entry point, the following chart may be of some value, from SeasonalCharts.com:

US Bonds Future saisonal

This shows 30 years of the 30-year T-bond futures contract. I believe this amounts to something like a total return chart, because the bond did not increase in price 6 points per year; that would be 180 points over 30 years, whereas the bond now trades at 153 with 100 as par.

Given how badly the bond traded in the second half of last year, especially when it normally trades well, it is important to me to see it continue to reverse that underperformance if I were to be "all in" on the bull case.

Another technical that may also point to a renewed bull market in a few months, in line with the above chart, relates to sentiment on the 30-year bond. From FINVIZ, here is a weekly chart that shows an interesting and almost eerie similarity between the excitement of speculators on the bond in 2012 and last year:

As always, the green line represents the net positioning of commercial hedgers. The red line represents the net positioning of large traders, such as large hedge funds and commodity trading accounts; the blue line, that of the small traders. The sum of the red and blue lines equals that of the commercial hedgers (green line). Thus, tracking the green line provides the best way to assess the net positioning of speculators.

So, we see a large and sustained drop in the green line below zero through most of 2012, and after a brief bit of time above the zero line late in 2012 (election-related?), another large drop below zero in 2013. The 2012 drop, corresponding to a great deal of bullishness by speculators, was due to Operation Twist, when the Fed bought long-term Treasuries, paying for then with short-term Treasuries. So they were front-running the Fed in the setting of a decelerating economy.

We see something very similar in the pattern set in the first nine months or so in 2016 on the backs of what may have been a mild industrial recession in the US.

Each time, 2013 and later in 2016, this bullishness amongst speculators was reversed with a vengeance.

The two bull runs associated with speculative fervor, 2012-3 and 2016, are similar as to the duration and extent to which the specs went all in on the long side. Now we have a sell-off which has a bit longer to go to match the pattern of 2012-3, but based on that pattern, the high in yields may have been made, or nearly so. In 2013, the early September high in yields was 2.98% on the 10-year, followed by the marginal new high of 3.04% at the end of December. The 30-year was a little different, peaking at 3.91% in August and 3.97% at the end of December.

Based both on seasonals and the 2013 example, even a bond bull might expect another back-up in rates, possibly to a mild new reaction high in yields.

However, I'd point out two things, in addition to the "history rhymes rather than repeats" adage. One is that the Fed was pouring money full blast into the system all through 2013. The surprise if anything was that rates did not blast higher through that whole process. In sharp contrast, the Fed is now raising rates and shrinking the base money supply. That's much more of a "taper" (2014) and post-taper activity, and the entire 2014 and beyond trend in rates has been more down than up.

The other is that both the 10- and 30-year bonds have set lower highs than they did in 2013.

Of course, all traders are well aware that numerous moving averages have been violated to the upside by rates, yet the long-term downtrend remains in its well-established channel:

Now a word on commodities and interest rates.

No major signal from commodities

The oil complex, most simply crude oil, has a strong correlation with interest rates going back at least to the 1970s. When oil soared in 1973-4 and again in 1979-80, so did interest rates. Oil price crashes in 1985-6 and 1998 were associated with plunges in interest rates. When oil (and stocks) crashed in H2 2008, so did interest rates, which bottomed in December and headed up along with oil prices.

Now, following its massive sell-off beginning in 2014, oil prices are treading water, showing no zip. The same goes for lumber prices, which are often good leading indicators of the economy and rates, due to their domestic orientation and use in homebuilding. However, a more globally-sensitive commodity, copper, has re-entered a bull trend. So, overall, commodity prices are neutral. I do want to prognosticate a little on oil, though. I wrote several bearish articles on oil in 2014, which tied into my newfound emphasis on biotech stocks, but by Dec. 30, 2015, I wrote an article on oil and oilpatch stocks with these bullet points:

  • I turned bearish on oil stocks in the spring of 2014.
  • With oil finally below $40, a groundswell of anxiety and growing bearishness has made me begun to look turn bullish on selected assets.
  • This article discusses the evolving reasons to begin to tack against the wind in oil, and the specific investments I have chosen.

That article also pointed to oil seasonality as important, noting that crude prices tended to bottom in February, which is what occurred. It's important to see if that happens again. Here's why I'm watching for this not to happen this year. It stems from my opinion of the macro chart on oil prices, as shown on a weekly chart from FINVIZ:

One negative I note is that since 2012, speculators in crude oil have gotten increasingly bullish. They are now maximally bullish. They have also been wrong, most so when they have been the most bullish. Just look at their extreme optimism in 2014, as prices were set to plummet. The current chart looks like a fractal of the 2014 set-up, only at a lower price point.

If seasonal strength as February turns to March is absent, my bias from the charts is for lower prices, which is bond-bullish.

A second reason not to be in love with oil comes from the term structure of prices out to the Dec. 2025 on the futures market. While spot prices get the headlines, as they should, I also track the far out years to look at what market participants expect years out. This price is down to about $58 per barrel, and has been flat to down for many months.

All things considered, the bond-bearish signals that commodities gave from 2002 until the first part of 2008, and again after the crash until 2011, are absent.

One may wonder why gold hasn't been mentioned. That's because gold used to rise with interest rates. Since the Great Recession, the relationship has been more complex. Often, both gold and bond prices, not bond yields, have moved in the same direction, driven either by fear of financial calamity or optimism. Similarly, gold used to move closely with oil, but that relationship has also broken down.

What's bond-bearish: Trump? Structural Federal deficits? Other factors

Understood that interest rates are "low," and therefore "should" revert to some theoretical normal level, the more interesting questions are what will make them "normalize."

One common topic of bond bears is protectionism from a Trump administration. I agree that's something to consider; certainly that fear helped drive rates up from such low levels after the election to a less abnormal range. My own preference as an investor is to see what the administration and Congress actually do. To some extent, a program that involves more production in the US and less of a trade deficit means less need to stuff the rest of the world full of dollars, which weakens the dollar. So, there are offsets in that an intelligent "America first" comprehensive policy of less offshoring may not be, on balance, inflationary.

More important to me are the large and growing structural Federal deficits in association with $20 T of Federal debt. The tendency to monetize these debts is going to be great. On the other hand, Japan has been going down that road for many years, and interest rates are around zero there. What has happened there and in the EU amounts to treating Federal spending as if it has been done by cash. Somehow this paradigm "works" and so I'm reluctant to ignore the possibility that somehow it or some similar interest rate structure will occur in the US.

And, of course, there's the overriding goal of policy-makers to create inflation, which is bond-bearish. So nothing is a lay-up here as far as the future of interest rates.

Now it's time to finish this article and lay the ground for the final article in the series, dealing with thoughts for investment strategies.

Concluding remarks - why assume a breakout in rates?

When one looks very carefully at cycles of low interest rates, one finds prolonged bottoming periods. Just as the topping period of 10% or greater rates on 10-year Treasuries lasted from about 1974 to 1987, bottoming periods have lasted as long or longer. If we say that rates below 3%, or even as low as 2.5%, on the 10-year bond are required to call them extremely low, then that rate was only first reached in 2008, and was last reached again just three years ago, on Dec. 31, 2013. Thus there could be many years of rates in this range based on historical precedent.

This is important because if long-term rates stay stable, then certain low-risk strategies involving the "rolling down the yield curve" phenomenon become worth considering, especially for retirees and conservative investors. Briefly, this strategy takes advantage of the upsloping yield curve. A 10-year bond may yield 2.5% and an eight-year bond may yield 2.0%. If one buys a 10-year and holds for two years, the assumption from that upsloping yield curve is that two years after purchase, the then-current rate on the eight-year bond will be higher, so that one cannot sell the 10-year bond for a capital gain. However, if the eight-year bond is still at 2.0%, the buyer of the 10-year bond now owns a bond with eight years to maturity, but the coupon is an above-market 2.5%. If this bond was purchased at par of $100, it now has to be marked up (to $103.7) to give a market yield to maturity of 2.0%.

Thus, strangely, a stable interest rate structure can allow capital gains. Bond managers have been profiting from this phenomenon irregularly since 1981.

In any case, no one knows what's coming, but few doubt that the era of high stock market valuations began by 1995; maybe earlier. Yet, here we are, and except for the two intervening recessions, and valuations are still high. Bonds at least have entered very high valuations (low interest rates) much later than stocks, so perhaps they will leave that zone later as well.

To be clear, as I said in Part 1, You Can't Kill Mr. Bond, my favored investment approach remains cautious, in favor of an overweight to cash, near-cash such as short-term debt instruments, and certain other sectors. I continue to believe that this is a difficult time to invest, as occurs in late-cycle stagflationary environments. One week it looks as though inflation is surging, another week the economy is surging, the next week oil prices are crashing, the next week the economy might be slowing or even declining. I'd rather miss some upside than just guess and, so often, get it wrong.

This series was conceived when 10-year Treasuries were a little higher in yield, around 2.5%, but the main point is that given seasonality and extreme bearish sentiment, January may be a good time to think about investment strategies for the months ahead, do research, and preposition assets such as cash if desired. When the Fed is hawkish, bonds usually end up benefiting.

I'll go into my picks and pans for both stocks and bonds, and metals, in the final installment of this series planned for later this week. Such funds as the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) and the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG) are discussed, along with individual stocks and bonds, plus stock market sectors that may benefit from current inflation and Fed policy trends. Thanks for reading and for any comments you may wish to share.

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

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.

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