The Only Thing That Will End This Bull Market

by: Eric Parnell, CFA


No, not that bull market. This bull market.

So many theories on why this bull market will end.

Only one reason why it actually will, and this reason remains stubbornly non-existent despite the best efforts of policy makers.

This bull market is likely to remain ongoing for the foreseeable future.

No, not that bull market in stocks. This bull market that has been going on for roughly four times longer in bonds. Talk has picked up again recently by analysts casually talking about the various reasons why the bull market in bonds that started all the way back in the early 1980s is suddenly about to end. And, while the logic behind these arguments certainly seems sound, the reality remains that there is only one thing and one thing only that will end the bull market in bonds. And, this threat is nowhere to be found at the present time.

Bull Versus Bull

It is an interesting dichotomy. If one took to the airwaves or the blogosphere to state that the end of the bull market in stocks (SPY) was nigh, they would be subject to scoffs and looks of derision from the peanut gallery as respondents lashed back with a cat o’ nine tails style verbal retaliation. Heck, the mere mention that stocks (IVV) might enter into a garden variety short-term correction can result in accusations of “perma bearishness” and suggestions that the “sky is falling” anymore.

But when it comes to bonds (BND), one can easily slip this into the conversation, and nobody seems to notice. Instead, it is received with the customary “ah, yes” head nods and “of course, it’s only just a matter of time at this point”. Perhaps those that have remained bullish on bonds (AGG) over the past four decades are too busy buying the bonds that others are willing to sell during these inevitable periods of handwringing that occur at any given point in time, but what is considered utterly absurd for one asset class is understood as inevitable for another.

The reality is that both stocks and bonds are overvalued asset classes. And, both have been overvalued for some time, with this premium having been amplified in recent years, thanks to the once extraordinary monetary policy from global central bankers designed to rescue the worldwide economy from its imminent destruction nearly a decade ago now that has become both ordinary and commonplace in the years since.

The fact that they are richly valued does not mean that the bull market in both is not still very much intact. This is absolutely true of both at the present time.

But when asset classes are overvalued, they must be handled with extra care and a sharpened eye toward the potential for downside risk. For once the mean reversion in valuations is finally unleashed, it can be relentless and unforgiving in playing out over time as the simple laws of gravity dictate that assets typically do not bounce back to historically premium valuations (unless, of course, extraordinary policy intervention seeks to engineer a different outcome until any such distorting resources are exhausted).

Thus, it is worthwhile to carefully consider the reasons why the bull market in bonds may be about to end. Are they justified?

The Latest Reasons Why The Bond Bull Is About To Die

Let’s consider some of the recent reasons cited as to why the end of the bond bull market is nigh.

To begin with, faded from the discussion is the classic “sustained economic recovery is about to get underway bringing with it higher inflation” thesis. That, of course, was the narrative from late last year that was supposedly inspiring the investor rotation out of bonds and into stocks, never mind the fact that no actual evidence ever existed to suggest this was what was really taking place. (China (FXI) liquidating their U.S. Treasury (TLT) holdings in the second half of 2016 in support of their banking system in battling against capital outflows certainly looks a lot different than U.S. investors rotating out of bonds and into stocks. But who’s double checking on these types of facts anyway, right?)

Instead, now headlining at the “bond bull is about to die” theater are the following two acts.


First, the U.S. Federal Reserve is about to announce the start of Quantitative Tightening on Wednesday following its latest FOMC gathering. This involves the shrinking of a balance sheet that had previously quintupled from less than $900 million in 2008 as much as $4.5 trillion in 2014 as the Fed first won the battle of pulling the global economy back from the brink but ultimately lost the war in trying to continue to use in vain the same policy stick to beat the U.S. economy back into a sustainably strong economic recovery. This is a loooong overdue shift in policy by the Fed that I wholeheartedly applaud.

But the commencement of this program has many experts proclaiming that with the Fed now acting as a net seller of bonds, that interest rates will be ready to begin their march higher. Are these concerns valid?

Let’s consider the following facts. The Fed has already stated that it is going to begin very, very slowly with its balance sheet reduction program. Moreover, it is not going to begin with selling bonds, but instead is going to let some, not all but some, bonds that are maturing roll off the balance sheet without using the proceeds to purchase more bonds. At the start of the program, this planned roll-off is expected to total in the tens of billions per month at most. In a U.S. Treasury market that is measured in the tens of trillions, the loss of an incremental buyer no longer using the proceeds from their bond maturities to buy more bonds (not “selling” mind you, but simply “not buying more”) is not likely to make much of a sustained difference in bond prices at the end of the day.

Of course, it should be noted that the Fed intends on gradually expanding its QT program over time. Thus, it is likely that “not buying” will eventually evolve into outright “selling”. But even if this is the case, it should be noted that the Fed will still remain a marginal seller in a vast Treasury bond market of which it is almost certainly will work actively to make sure that it does not disrupt with its actions. (After all, the Fed does not mind disrupting markets for extended lengths of time when it means asset prices are going higher; but it has repeatedly demonstrated that it will immediately go out of its way to make sure that it is not causing a mere ripple when it might even be potentially causing asset prices to go lower even for a few days.)

It is also worthwhile to remember an important distinction about the Fed and its supposed role in inflating bond prices throughout the post crisis period. While it is still assumed to this day that the Fed’s bond purchases are the primary reason why Treasury yields are so low today, the actual evidence has been to the contrary. Not only did Treasury yields actually rise during the specific periods of quantitative easing (QE) when the Fed was buying bonds and fall during the specific periods when the Fed was not buying bonds, but Treasury yields did not reach their historic lows until nearly a year after the Fed made its last outright Treasury purchase as part of a QE program.

This leads to the following logical consideration. If the Fed’s bond purchases did not cause Treasury prices to rise and yields to fall, why would the Fed’s bond rolloffs and eventual sales result in Treasury prices falling and bond yields rising? And, if the Fed’s bond purchases caused Treasury prices to fall and bond yields to rise, is it possible that the Fed’s bond roll-offs and sales could actually end up causing Treasury prices to rise and bond yields to fall due to the associated effect on the change in investor appetite for risk assets in general? Only time will answer these questions, but to simply conclude that yields will rise because the Fed is about to commence QT is woefully inadequate.

Tax Reform

Let’s move on to the second headliner, which is that tax reform may result in a ballooning of the Federal budget deficit and an increase in the national debt that will cause Treasury bonds to sell off and bond yields to rise.

I’ll begin this assessment by saying that despite the latest glimmers of hope over tax reform, that the probability of it actually happening anytime between now and the end of the decade is virtually nil. There is a reason that the last time major tax reform took place was more than three decades ago. It is because it is really hard to do and requires both sides of the political aisle to really want to be on board to make it happen. Even then it is a heavy lift that requires a lot of bipartisan concession and compromise. Today, the party that is in the majority cannot even find common ground within itself, much less with the opposition. But what about recent signs of bipartisan compromise with the Democrats and the White House? Sure, it’s something. But tossing around a few ideas in exploring potential common ground over topics like immigration reform over Chinese takeout and chocolate cake one evening is a skosh different than having both parties together to sign major tax reform. In short, it just ain’t going to happen anytime soon.

Now, this doesn’t mean that we couldn’t see some window dressing tax cuts that policymakers try to parade around as tax reform. But if anything happens, it’s going to be on the margins, is likely to be more focused on the middle class than trickle down, and may not be the boon to business that the market has been anticipating since before the turkey was carved last November.

Of course, the bigger question in this regard is whether any tax cuts that we might see before the end of the year turn out to be deficit neutral or end up increasing the deficit. Some analysts that have accepted tax cuts as given have postulated that the deficit ballooning program may induce a sharp rise in Treasury yields as a result.

But once again, while this thinking might make sense hypothetically, it does not hold up when measured against actual evidence. Consider the following.

Since 2000, the Federal budget as a percentage of GDP has shifted from more than +2% surplus to as much as a near -10% deficit to GDP in 2009. And, even in the years since the financial crisis when everything has returned to being even more awesome than ever according to the U.S. stock market (DIA), the U.S. is still running Federal budget deficits in the more than -3% range that have helped balloon the Federal debt as a percentage of GDP from just over 50% in 2000 to over 100% today. Yet U.S. Treasury yields have steadily fallen throughout this entire time period.

Given this ongoing contradiction, should we suddenly believe that adding say another $300 billion to the budget deficit in 2018 as a result of a tax cut program is going to be the proverbial straw that not only stops the downward trend in U.S. Treasury yields over the past nearly four decades but causes them to sharply rise? Put simply, I think not. And, if we have any doubt about this outcome, all one has to do is look around the rest of the developed and emerging world to see economies piling on debt and seeing their bond yields continue to fall at the same time. I’m not saying this is a good thing by any means. It’s a really bad thing in my view, as a matter of fact. But as capital markets repeatedly teach investors over time, just because logic suggests that something supposedly should happen does not mean that it will.

The Only Thing That Will End This Bull Market

No. The only thing at the end of the day that will end the ongoing bull market in bonds is the following. It is inflation. Virtually, nothing else seems to matter outside of the potential of an outright U.S. government default (not the shut down the government threat of default nonsense, but real default) whether we think it should or not.

Consider the following historical relationship dating back to the Eisenhower administration more than 60 years ago. In short, when the rate of inflation has been sustainably rising over time, so too have U.S. Treasury yields (IEF). And, when the rate of inflation has been trending lower, so too have U.S. Treasury yields.

In fact, this relationship between inflation and yields has been true dating all the way back to the Grant administration nearly a century and a half ago, as bond yields remained consistently below 5% as the U.S. economy regularly bounced back and forth between inflation and deflation up until the end of World War II.

While a near 150-year sample size may be insufficient for some to draw any definitive conclusions, it is a meaningful observation that warrants considerable weight in my view.

Implications For The Bond Bull Market Today

What does this mean for today? The nearly four decade bull market in bonds is almost certainly not going to end until we finally begin to see a sustained rise in inflationary pressures in the U.S. economy. It seemingly will not matter how much debt the U.S. government piles on from here.

For anyone questioning how long these principles can sustain themselves, one has to look no further than the once second largest and now third largest economy in the world in Japan. Its debt as a percentage of GDP was once as low as 38% in the early 1990s. Today, it is essentially a mind boggling 200% and rising. Yet, as long as sustainable inflation pressures are nonexistent and the forces of deflation continue to dominant, bond yields are remaining persistently low even with bouts of fleeting inflation along the way.

Thus, when considering the U.S. economy, sustained inflationary pressures remain stubbornly elusive. For no matter how much money gets printed, and no matter how much in the way of animal spirits policymakers seek to conjure up, pricing pressures remain stubbornly soft. And, this is likely to continue even more so as policymakers slowly try to sneak the punch bowl out of the hollow global financial market party.

All of this leads to the final logical question for consideration. If all of the stimulus in the world could only generate this meager amount of inflation, what is the pricing environment likely to be when all of this stimulus is removed and the global economy is forced to stand on its own. An optimistic take would be that the inability of corporations to simply lean on financial engineering and share buybacks to generate EPS growth might spark an increase in capital expenditures and ultimately lead us to the inflation that has been so elusive for so long. But the more realistic baseline case is that despite the most extreme efforts by policymakers over the past decade in the U.S. and three decades in Japan, that deflationary forces are likely to still dominate over inflationary forces as the overhang of excess global capacity that has accumulated over so many years finally needs to be worked off once and for all.

What does all of this mean for the U.S. bond bull market that is running on nearly four decades and counting? It is bullish, as it is likely to continue for the foreseeable future.

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