Bond Bear Market Still Intact

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About: iShares 20+ Year Treasury Bond ETF (TLT), Includes: IYR, O, SPY, STOR, XLU
by: KCI Research Ltd.
Summary

Sovereign bond prices topped in 2016 (yields bottomed).

Bonds have rallied, however, the secular top (low in yields) from 2016 is still intact.

Investors should expect bond yields to head higher, not lower, especially at the longer-end of the yield curve.

"A 60:40 allocation to passive long-only equities and bonds has been a great proposition for the last 35 years …We are profoundly worried that this could be a risky allocation over the next 10."

Sanford C. Bernstein & Company Analysts (January 2017)

“Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria”

Sir John Templeton

“Life and investing are long ballgames.”

Julian Robertson

Introduction

Since 2016, I have been bearish on bonds, periodically owning puts in the iShares 20+Year Treasury Bond ETF (TLT), and writing about this positioning privately, and publicly, on Seeking Alpha.

A sampling of my public writing on this topic includes the following articles:

Lower For Longer Is No Longer Certain - October 8th, 2018

The Bond Bubble Is Bursting - Published On October 7th, 2016

Are We At The Point Of Maximum Financial Risk For Bonds? - Published On August 26th, 2016

The Bond Bubble Is About To Burst - Published On August 9th, 2016

The Irrational Fear Of Deflation - Published On June 17th, 2016

Inflation Is Coming, Are You Prepared? - Published On March 11th, 2016

While sovereign bond yields have indeed risen materially from their 2016 lows, particularly in the United States, there has been a pullback recently, which has caused many to think that yields are headed lower from current levels.

I disagree with this building consensus, and I think there is a set-up for higher bond yields, particularly at the long-end of the curve that is playing out.

Investment Thesis

Sovereign bond yields bottomed in 2016, and this was a secular bottom, so look for bond yields to make new highs in the months and years ahead, not new lows.

Surveying The Landscape

Clearly, there has been a pullback in sovereign bond yields in late 2018 that has continued into 2019, fueled by fears of slowing global economic growth and the eventual certainty of the next recession, due to the length of the current expansion, as the following five-year charts of the 10-Year Treasury Yields from Germany, Japan, the United Kingdom, and the United States illustrate below.

(Source: Author, Stockcharts.com)

Looking at the charts above, German, Japan, U.K., and U.S. 10-Year Treasury Yields all bottomed in the middle of 2016, which was a secular bottom that has not yet been broken, however, there has been a substantial pullback in each country's Treasury Yields from their respective 2018 highs, with the German pullback the longest, and deepest, while the U.S. 10-Year Treasury Yields have held up relatively well.

A Rising Stock Market And Falling Yields?

Interestingly, the broader U.S. stock market, as measured by the SPDR S&P 500 ETF (SPY), has rallied robustly in 2019 without a commiserate rally in Treasury Yields, specifically longer-term Treasury Yields.

(Source: Author, Stockcharts.com)

This has broken the general high level of correlation that has existed since 2016 between rising yields, and a rising stock market, though one needs only to look at the longer-term chart above to show that the S&P 500 Index has rallied previously alongside declining yields, notably from 2011-2016.

With the pullback in yields, yield-oriented sectors like REITs, as measured by the iShares U.S. Real Estate ETF (IYR) have led the rebound rally in 2019, with IYR, and many individual REITs, including popular Realty Income (O) and STORE Capital Corp. (STOR), actually making new all-time highs.

(Source: Author, Stockcharts.com)

Utilities, as measured by the Utilities Select Sector SPDR Fund (XLU), which are another interest rate sensitive sector, have also made new all-time highs too.

(Source: Author, Stockcharts.com)

Is there anything that could put an end to this Goldilocks scenario of a rising stock market, declining longer-term yields, and a never-ending bid in yield-oriented assets?

The answer is a firm yes, however, it takes a little imagination, and looking forward instead of looking backwards.

Wage Pressures And Rising Commodity Prices

Now reading the headline of this section, I am sure most are asking, "what wage pressures?" and "when have we seen sustainable rises in commodity prices?"

Specific to wage pressures, in the February Employment Report, wages increased by 3.4% over the past year, their fastest pace of increase since the current economic expansion has begun, as the following chart illustrates.

(Source: Bureau of Labor Statistics, FRED, MarketWatch)

Clearly, from looking at the data above, wage growth has been accelerating for a long time now, with a notable turn higher over the past year.

Specific to rising commodity prices, $WTIC crude oil is higher by 28.3% year-to-date in 2019, after plunging to end 2018.

Obviously, oil prices have been very volatile, however, since their bottom early in 2016, oil prices, as well as most commodity prices, have generally headed higher.

(Source: Author, Stockcharts.com)

Rising wage pressures and rising commodity prices have caused record high profit margins to begin to contract, which is not evident yet since we are at the very early phase of a trend change, and this could be the start of a historic reversion-to-the-mean contraction in profit margins.

What To Look For Going Forward

With the consensus expectation now for zero Federal Reserve interest rate hikes in 2019, the stage is set for the yield curve to steepen if domestic, and global economic growth, pick up from current levels, or simply exceed downtrodden expectations.

In fact, the potential steepening of the yield curve already appears to be gradually happening as the spread between 10-Year and 2-Year U.S. Treasury Yields shows.

(Source: Author, Stockcharts.com)

Looking at the chart above, the "10-2" spread has been steepening since late 2018, albeit ever so gradually.

TLT Puts Continue To Offer Opportunity

With the recent rise in the iShares 20+Year Treasury Bond ETF from its late 2018 lows of roughly $111 to recent highs above $121 per share, I think the opportunity remains on the short side, specifically with TLT put options.

(Source: Author, Stockcharts.com)

Why is the opportunity on the short side with TLT put options?

Specifically, I believe a lot of the bad headlines from a global economic slowdown have already been priced into the market.

Additionally, from a technical perspective, since TLT peaked in the middle of 2016, which was the top in sovereign bonds (low in yields), there has been a series of lower highs, and we are set up for a lower low.

Closing Thoughts

At first glance, the recent declining long-term sovereign bond yields appear to be problematic, especially when mixed with the narrative of slowing global growth and a looming recession, until you compare these sovereign bond yields to their 2016 lows.

It is easy to forget now, however, in 2016 deflationary fears were running rampant, as the following chart shows.

That peak in deflationary fears happened to coincide with the top in sovereign bond prices (low in yields), which occurred in the middle of 2016.

Recent fears about a downturn in global growth, led by a downturn in China, have caused a secondary peak in sovereign bond prices that is occurring right now, however, once this storm passes, the secular turning point in 2016 will be cemented, and sovereign bond yields will have a lot of room to run higher, from their current levels.

Once the bond market rolls over once again, look for a capital rotation, highlighted by a move from growth-to-value, that has a chance to rival, or exceed the capital rotation that took place from 2000-2002.

Bigger picture, fundamentals still do matter, fundamentals were always the wrong scapegoat, and I still believe 2019 is going to be a banner year for value equities, as price discovery, after a decade of growth outperforming value, is poised to return with a vengeance.

To close, even though it has been a very difficult almost decade-long stretch for value-oriented investors, with pockets of significant out-performance, including 2016, I think we are about to enter a golden age for active, value investors, who do the fundamental work, who can find the future free cash flow leading companies, and the most out-of-favor sectors and the most out-of-favor equities, including this recent public write-up, will be at the forefront of this opportunity.

Thank you for taking the time to read this article.

WTK

Disclosure: I am/we are short TLT VIA PUT OPTIONS AND SHORT SPY IN A HEDGED PORTFOLIO. 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: Every investor's situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.