Still Bullish On Bonds

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by: Eric Parnell, CFA
Summary

The bond market shocked investors midweek with a sudden and sharp rise in yields.

Has the inflationary beast finally been unleashed?

The answer along with the many reasons why I remain still bullish on bonds.

The bond market delivered a shock to the system this week. After quietly ending the trading day at 3.05% on Tuesday, the 10-Year U.S. Treasury yield exploded to the upside on Wednesday by 10 basis points to close at 3.15%. The benchmark Treasury yield reached as high as 3.21% early Thursday before settling back into the afternoon. This is a big move for bonds in just two trading days - think 70 points falling off the S&P 500 Index in a similar amount of time - and it raises an important question that many bond investors are left pondering as we head toward the end of the trading week. Is the long elusive inflationary beast finally being unleashed on capital markets?

The answer is no. The sudden rise in U.S. Treasury yields was indeed notable. But the rise in yields starting on Wednesday morning has little to nothing to do with a rise in inflation or even inflation expectations for that matter. Instead, the rise in yields is likely much more about something else entirely different, but more on that point later. But without inflation, this bond bull market remains intact. And with the onset of any future weakness in global economic growth, it continues to thrive.

Fanning the inflation flames. The narrative behind the higher inflation argument is compelling. U.S. economic growth is strong, and the unemployment rate is historically low. Eventually, these forces will drive higher wage growth that will lead to too much money chasing too few goods and result in demand-pull inflation. At the same time, increased wages coupled with higher input prices thanks to the ongoing trade war with China and rising oil prices will also spark cost-push inflationary forces. How in the world could inflationary pressures not ignite? Throw in the repeated proclamations by Wall Street titans and higher inflation is a seeming fait accompli.

Always do your homework. But here's the problem with this conclusion. It is the problem that has existed dating back to the days prior to the financial crisis. And it is the problem that will likely continue to frustrate those waiting for the inevitable inflation outbreak that seems to never actually happen. What is the problem? The underlying data continues to work squarely against this conclusion. Come with me as we take a walk through the data explaining why.

Inflation. We'll begin by keeping things simple and looking at the inflation data. At first glance, it seems that inflationary pressures are starting to accumulate. One need look no further than the Consumer Price Index (CPI), which has been steadily rising since early 2016. Never mind the fact that the current reading at just below 3% is no higher than it was in early 2017 and is still well below where it was back in 2011 and 2012, both of which were times in the recent past where inflation was widely warned but never actually took hold. The trend is definitively on the rise, ergo inflation is coming! Right?

Not so fast. Remember that this is headline inflation that includes energy prices. Remember when we were paying nearly $5 per gallon at the pump back in the summer of 2008? You can see it on the chart above in the area that is now shaded for recession. This was not inflationary in any sustainable way. Instead, it was the last gasps of an economy about to descend into crisis. And if we've learned anything in the years since - say in 2015 and 2016 - it is that oil prices sure can be volatile. So, we need to strip energy prices out to see if we can find inflation pressures in any sustainable way.

When looking at the Core CPI that excludes food and energy prices, we see that the latest readings on inflation are now well over 2%. Notable indeed. But nothing that we haven't seen before in 2011, 2012, 2015, 2016, and 2017. Inflation remained elusive during these past episodes. And we are no higher today. If anything, I might be selling inflation if I were a technical channel trader. But I'm not.

OK. So we see some possible very early signs of potential inflationary pressures in the data, but absolutely nothing definitive as of yet. Let's dig deeper.

Inflation expectations. A ha! You're looking at historical data Parnell. And everyone knows that the CPI is a lagging indicator. It's all about inflation expectations! Indeed. Let's take a look.

Consider the chart of the 5-year breakeven inflation rate, which provides a measure of expected inflation derived straight from the markets. From my perspective, I'd much rather rely on what is being signaled by capital allocated in the marketplace on each and every trading day over the notions that some Wall Street legend might be gun-slinging from the hip at the podium during some big wig conference on any random trading day. And what does the market expect on the inflation front?

Put simply, Wednesday gave us the highest reading on expected inflation at 2.05% since - wait for it - September 25. And it already retreated by a basis point to 2.04% on Thursday. Moreover, expected inflation today is still well below the 2.15% peak readings from back in mid-May. If anything, expected inflation has been trending lower over the past four months, not higher.

Taking this one step further, future inflation barely above 2% are hardly anything that could be considered blistering. In fact, it's barely above the Fed's target rate.

Also, from a longer term historical perspective, inflation expectations are still considerably lower today than they were throughout most of the period from 2010 to 2014. Sustainably higher inflation never came to pass in the first half of the decade, and if anything, the recent rise in inflation expectations to date is nothing more than a mean reversion from historically low levels in 2015 and 2016. Whether we revisit these lower levels or beyond during the next economic recession remains to be seen.

The economy. Recession!?! How can I be talking about the next recession in the context of today when U.S. economic growth brimming? And if the U.S. economy is growing, the inflation threat remains very much real and it is possible that the market is underestimating the possibility. Good points to consider.

First on the economy. Yes, the reading on 2018 Q2 real GDP growth at 4.2% was indeed strong. The tax cuts implemented at the end of 2018 certainly played an important role in driving this outcome. But is this growth sustainable? Economists seem to have their doubts.

For example, according to The Wall Street Journal's Economic Forecasting Survey of more than 60 economists, projections for real GDP growth in the next few quarters are the following: 3.2% in the third quarter and 2.9% in the fourth quarter in gliding back into a 2.4% growth rate for most of 2019. Of course, a real GDP growth rate of 2.4% sounds strikingly reminiscent of the growth rates we were seeing prior to the tax cuts. Sounds more like a tax cut induced sugar high over anything sustainable. Also, if higher inflation didn't take hold before in this more subdued economic growth environment when central banks were injecting liquidity like there was no tomorrow, why should we presume it will take place in the future when central banks are draining liquidity from the financial system instead?

Economic growth. But what if the economists are wrong? What if economic growth surprises to the upside and brings higher inflation than the market is currently pricing in? (never mind the possibility that they could be wrong and the economy could be well on its way toward recession by this time next year - insert collective audible scoffs of derision here).

Here are a few reasons why growth does not appear likely to surprise to the upside in the near-term.

First, the lion's share of the treasure derived from the corporate tax cuts continues to flow its way back out the door into the deep pockets of shareholders from which much of it is likely to never be spent on consumption or expended on capital goods (remember the wonders that the "wealth effect" was supposed to deliver to the U.S. economy in the first half of the decade? Thanks Ben, great plan albeit well-intentioned).

Second, both developed international and emerging markets appear to already be well on their way in heading in the exact opposite economic direction from stronger economic growth as implied by their market charts below. Remember that globally synchronized economic growth narrative coming back in January of this year? Yeah, so do I. As for the decoupling narrative I'm hearing more of today, I remember when that one was in vogue for commodities and emerging markets back in 2008. Turns out, not so much.

So what other than higher after tax corporate earnings helps explain why U.S. stocks are hitting new highs when the rest of the world appears to have already packed it in on route to the downside? See the first reason above for a primary driver.

Lastly, the money supply and its associated velocity are telling a very different tale about expected economic growth and associated inflation. When M2 money stock growth is rising and/or the velocity of the M2 money stock is increasing, the conditions exist to foster a stronger economic growth trend. Conversely, if M2 money stock growth is falling and/or the velocity of the M2 money stock is decreasing, economic growth is likely to remain more lackluster and subdued.

So, what are the current money supply and velocity of money readings in the current economy? The charts below speak for themselves.

The velocity of money has been falling since before the onset of the financial crisis. As for money supply growth, it has been steadily decelerating for nearly two years now. These forces alone help explain why economic growth has been less than stellar throughout the post crisis period as well as why inflationary pressures have remained relatively benign. Perhaps these readings will finally break out of their more than decade-long malaise at some point in the future. But until they do, we should expect that economic growth beyond any current sugar highs is more likely to be subdued than exceed expectations. And if economic growth remains subdued, so too will inflationary pressures.

Should versus Is. I could continue on for many more pages discussing further reasoning and citing additional data supporting the notion of why inflationary pressures are not poised to ignite now or anytime soon. Perhaps I will revisit some of these additional themes in future articles on the topic. But while the conversational narrative about why inflation should be higher today, the underlying hard data largely continues to paint an entirely different picture not only helping to explain why the "mystery" of missing inflation throughout the post crisis period but also suggesting why pricing pressures are likely to remain subdued for the foreseeable future. Maybe inflation should be higher, but it simply is not according to the underlying data.

Tilting the scales. OK. If inflationary pressures remain benign, this does not necessarily mean that bonds are heading higher (and yields lower). Why then the still bullish view on bonds? I remain bullish on bonds, specifically long-term U.S. Treasuries (TLT), U.S. Treasury Inflation Protected Securities (TIP) and taxable municipal bonds (BAB) with the view that yields will eventually fall back to the downside (and prices move to the upside) for the following reasons.

First, we are currently in a historically long economic expansion with a stock market at historically high valuations. Eventually, the U.S. economy will fall back into recession, and when it does investors will flock not to the risk of speculative stocks trading at premium valuations but instead to the safety of U.S. Treasuries.

Also, Fed policy actually favors bonds over stocks. What? How can the Fed raising interest rates be good for bonds and bad for stocks? Because the only way that stocks continue to rise in a Fed tightening cycle is that companies can generate growth that runs ahead of the increased cost associated with higher interest rates. But we've already seen by a number of metrics that future growth is likely to be more subdued at best.

Yet despite this reality and inflation pressures that remain largely in check according to the data, the U.S. Federal Reserve has made bold assertions about their future plans. Reading between the lines, Fed Chair Powell is basically saying that the FOMC is going to take as many quarter point rate hikes that it can get before the lights finally go out on the current economic expansion and the ongoing stock market party, even if the underlying data suggests that they could take a more measured approach. What does all of this add up to? A point somewhere potentially in the not so distant future where the economy is falling toward recession, where premium priced stocks are finally starting on the long road toward regressing toward the mean, and where investors are migrating toward the safe haven of U.S. Treasuries. Perhaps this helps explain why the yield curve remains as flat as a pancake today despite all of the current excitement about the U.S. economy and the supposed inflation threat.

Wait a second. Why own TIPS then? Because TIPS give the best of both worlds in acting like a Treasury bond when economic times are tough (disinflationary to deflationary) but providing inflation protection in the event that pricing pressures do actually ignite. In short, they provide a favorable bond hedge with a relatively low return correlation to the nominal bond market to boot.

What about the ever-growing fiscal deficits and national debt in the U.S.? Won't this increasingly supply of debt put downward pressure on bond prices? My response to this point is one word: Japan. Here's a country whose national debt would leave the most profligate fiscal policy maker blushing with monetary policy actions in recent years that have been absolutely jaw-dropping. Yet the 10-Year Japanese government bond yield remains, after its massive recent spike no less, at a whopping 0.16%. This, of course, is more than three percentage points below what the 10-Year U.S. Treasury bond is yielding today at 3.19%.

So, while a 3% yield may sound low in a country that is borrowing like the U.S. continues to today, what Japan demonstrates is that it can fall much further still even with rapidly rising debt levels depending on how economic circumstances play out. And even if long-term U.S. Treasury yields fell no further than their levels from 2016, this would imply more than +25% total return upside from current levels. Not too shabby.

Who is going to buy these U.S. Treasury bonds? Perhaps the institutional and retail investors that have steadily purchased more than a half a trillion dollars in bonds since the start of last year according to the Investment Company Institute. This, of course, stands in stark contrast to the more than -$125 billion in domestic equities that these same investors have been selling on net over this same time period despite the fact that the U.S. stock market remains near all-time highs. If anything, investors should spend far more time wondering who is going to buy these stocks once corporations start scaling back on their breakneck stock buyback programs.

Why then the sudden spike in yields on Wednesday? OK. So, if it wasn't concerns over inflation that were supposedly sparked by the ISM Services report at 10AM ET yesterday (first of all, I am highly dubious that it had anything to do with the ISM Services report - of all economic data that might finally awaken a market to inflationary concerns, the ISM Services report probably doesn't even make the list much less rank high on it. And it can't be blamed on the ADP Private Employment report either, as this was released at 8:15AM ET and 10-Year Treasury yields were no higher than they were to start the week on Monday at 3.08% before they suddenly started to spike higher nearly two hours later), then what caused Treasury yields to suddenly start rising on Wednesday and into Thursday?

The answer is very likely the same reason that Treasury yields rose so sharply at the end of 2016. And the answer is also very likely the same reason that Treasury yields were surging higher at the end of 2017 into the start of this year. The answer is the sale (or perhaps liquidation) by major foreign holders of U.S. Treasuries in general and countries like China and Japan in particular, both of which are by far the largest foreign holders of U.S. Treasuries at more than one-third of the total. It will take some time before the official data become available to verify this answer, but it has been the culprit so many times in the past when the mainstream financial media and its pundits are pointing elsewhere to possibilities like inflation.

The key downside risk for bonds, and everything else in capital markets. All of this brings us to a few important points for consideration.

First, investors across all asset classes in general and U.S. stocks in particular should be very careful what they wish for. I hear so many investors flippantly proclaim that bonds are toast and stocks are going higher. But capital market history has repeatedly shown that this is a very unlikely combination in reality, particularly given how richly valued stocks are today even after the added boost of higher earnings from the corporate tax cuts. Instead, given that bond yields form the fundamental basis in determining stock valuations, if interest rates start surging higher across the curve, expect a pretty nasty bear market for stocks to come along with such an outcome.

As for bonds themselves, the greatest downside risk facing the U.S. Treasury market today is not the threat of inflation. Instead, it is the prospects that a major foreign holder of U.S. Treasuries (say China for example, with which we remain currently locked in an escalating trade war at a time when their economy is facing mounting challenges) starts liquidating either by choice or out of necessity. This risk has created spurts of short-term volatility for the U.S. Treasury market in particular and capital markets in general throughout much of the past decade, and this remain a key downside risk worth monitoring going forward.

Of course, this risk has also presented some of the most attractive bond market buying opportunities along the way too, such as at the end of 2016 when one could snatch up deeply discounted investment grade preferred stocks by the bushel and generate +20% capital gains to go along with the +6% yields at cost. Once again, not too shabby.

Still bullish on bonds. Putting this all together, I remain still bullish on bonds with a particular focus on the long-term U.S. Treasury and taxable municipal bond markets. I fully expect periods of short-term volatility along the way. And I would not be surprised if bond yields continued to rise from current levels into the near term. But as an investor, my time horizon in owning these bonds is not measured in weeks or months. Instead, it is measured in years that are likely to include the onset of the next disinflationary if not outright deflationary recession at some point along the way. And as long as inflationary pressures remain subdued according to the actual data and despite what some Wall Street legend may be saying at any moment in time, it remains prudent to stay long bonds as part of a broad asset allocations strategy today.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners and Retirement Sentinel makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners and Retirement Sentinel will be met.

Disclosure: I am/we are long TLT,TIP,BAB. 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: I am also long selected individual preferred and common stocks as part of a broad asset allocation strategy. I am also long selected stock mutual funds.