No Hunger Like Yield Hunger: This Bond Bull Could Run A Lot More

by: DoctoRx

Technicals are shaping up well for bonds, including the charts and sentiment measures.

Fundamentals pointing to ongoing disinflation or deflation also look favorable for interest rates to continue moving down in the US.

These points are fleshed out in some detail, with concluding commentary on investing in fixed income versus buying stocks for yield.

Investment thesis

The basic thesis is that it takes bulls to make a bull market, and the long bond (TLT) now has both the technical and fundamental backdrop to complete the bull market move it has made since the bottom of the bond bear market last October. I'll begin with some technical points, then move to a brief discussion of fundamentals for bonds.

A structural bull market in long-term interest rates...

I use the 30-year Treasury bond because its interest rate is set mostly by the free market, whereas even 10-year T-bond is moderately influenced by short-term rate-setting by the Fed. A long-term look at interest rates on TYX puts the latest move in its long-term bullish perspective, "bullish" referring to higher prices for bonds (i.e., lower interest rates):

Chart Data by YCharts

The gap about 15 years ago comes from the discontinuation of new 30-year bond offerings. Even lacking it, the structural downtrend in rates is clear.

...and a promising short-term bull market

When a long-term bull market is revived by the following sort of bear trap, as occurred last September and October, it usually deserves respect:

Chart Data by YCharts

I see this action as similar to those of every Fed rate hike, or rate hike cycle, that was always going to be "the one" in which rates were going to re-enter a rising rate, rising inflation cycle.

Why should the current story be different from the others? That is to say, why should long-term rates not once again descend to or below prior cycle lows (2.1% for the 30-year in mid-2-16)?

A bull market needs bulls, and they have appeared

There are three ways I am inferring that money has begun to move into bonds and that the move could last a playable length of time. One comes from the outperformance for over a year of XLU, which began generating alpha after the peak in the tech sector (QQQ) and SPY in late January 2018. This suggests that very smart money was looking to capitalize on the evolving fundamentals, in essence fighting the Fed's point of view of endless growth and accelerating inflation.

A second is to look at flows of funds by the investing public, which are favoring bonds over stocks lately. This typically has a shelf life of some duration if the fundamentals are in gear, which they are (more on them below).

Finally, FINVIZ shows speculative traders switching to the long side. Importantly, this now includes the large traders (blue line at the bottom panel) as well as the small traders (red line), who were the vanguards:

This pattern is similar to that seen in early 2016, when rates began crashing from 3.0% at year-end to 2.1% in early July in the aftermath of the shock Brexit vote, which coincided with the probable end of the global industrial downturn.

Having speculative large and small traders both positioned net bullishly means in the current context, good things for more downward pressure on yields.

A final technical point is not discussed much, and therefore could be especially important.

Investors are now used to 3-3.5% long bond rates, so 2% can finally be accepted as normal

The current 2.59% yield on the 30-year bond was breached to the downside in January 2015. This was the third such breach, having first gotten there in December 2008 as part of the panic part of the Great Recession. The second time this level was reached was in July 2012, following the 2011 slowdown and before growth and animal spirits in SPY were stoked by QE 3 in H2 2012.

Now the 30-year is hanging around 2.6%, and the psychology is ho-hum. After all, 30-year bonds from the UK, Japan and Germany are trading at much lower levels.

This pattern has been seen throughout the 38-year history of the declining long bond rate cycle. First 10% seemed too low (1982 recession), then it became resistance (crash period of 1987). Then 9%, which was resistance in the '80s, became the top rate possible prior to the 1990 recession. Then 7% fell, then 6-6/5%, then 5-5.25%, and now in the post-Great Recession period, it took a while, but now 4% is looking as though it was successful resistance (in 2013).

The pattern of lower highs and lower lows, but in a gradual testing way in which successively lower lows in rates are always proclaimed as the final low, may still be going on.

Now, let's look at the fundamentals. There are several structural and tactical bond-bullish points here. Beginning with an obvious structural factor:

Demographics are disinflationary or deflationary

Birth (fertility) rates all over the developed world are at or (generally) below replacement levels. Thus, population growth is largely from people living longer - usually as retirees - as well as immigration. Empirically and theoretically, this is a low-inflation set-up, where central banks have to work extra hard to get 1-2% inflation rates. While the US has had higher fertility rates, this is the latest from the CDC:

The provisional total fertility rate for the United States in 2018 was 1,728.0 births per 1,000 women, down 2% from the rate in 2017 (1,765.5), a record low for the nation...

The total fertility rate in 2018 was again below replacement-the level at which a given generation can exactly replace itself (2,100 births per 1,000 women). The rate has generally been below replacement since 1971 and consistently below replacement for the last decade.

These numbers do not point to inflationary pressures in any way.

Switching to a different type of topic:

The spread of high-tech into almost all sectors is deflationary

Information technology, defined broadly to include improved communications, is making many tasks, processes and systems more efficient. What I see happening is that Old Economy companies such as Deere (DE) and Caterpillar (CAT) are effectively using the Internet to improve efficiency in their customers. CAT, via telematics, may now effectively be in the SaaS business. All this is deflationary, productivity-enhancing stuff, and as it becomes universal in developed economies, it takes so many costs out of the system that it becomes difficult and pointless for central banks to hew to a 2% inflation target.

The spread of high-tech as well as a cooling global economy has led to deflation in some identifiable areas:

Deflation is already partially here, and much of it is "good deflation"

A few examples suffice. The first is crude oil, where both Brent and WTI are below levels first reached in 2005. In addition, the futures market price for WTI is lower in May 2023 than for the front month, showing price stability or deflation. What is the "right" four-year risk-free interest rate based on this pricing? Arguably it could be zero, or even a bit below zero.

Second, unit labor costs in Q1 dropped 0.8% yoy. That this occurred with a very low unemployment rate and ongoing wage gains implies significant productivity gains. This in turn suggests that the financial powers-that-be could in time move to accept a lower risk-free interest rate than they now do. This would be bullish for bond prices.

Third, import and export prices were down yoy by 1.5% and 0.7% respectively. Other broad measures of inflation are low, such as the CPI at 1.8% yoy and the PCE price index at a mere 1.5%.

Fourth, inflation expectations by the pros are very low, at 1.85% in the US for the closely-watched 5y5y swap, which measures the expected five-year inflation rate beginning five years from now. From about 2011 onward, this metric has correlated closely with the yield on the 10-year Treasury, which would suggest that at around 2.09% now, the yield could easily drop another 25 basis points (0.25%) with no special change in inflation expectations or realized inflation.

Economic history argues for caution; what about recession?

All the above is occurring while thinking that the US economy is growing. Perhaps the data will be revised to show that a recession has begun - this would not be the first time - but assuming that is not the case, the question must be asked, if inflation is so low now, with deflationary aspects to the current situation, what will happen if the US suffers another recession, not just a period of slow growth? Won't inflation truly take another big tumble, and won't Treasuries and other safe-haven bonds likely appreciate as rates drop to fresh all-time lows?

This is a possibility that all investors, whether leveraged short-term traders or long-term buy-and-hold types, may wish to consider.

Brief thoughts on fixed income investing in the current era

Just in case you are new to investing, the bond market is more varied than the stock market. A common stock is a perpetual claim on whatever corporate assets the board of directors chooses to distribute to shareholders, or to the value of the company if it is sold. All common stocks are similar in this regard. Whereas, there are countless issuers of debt in the US, and each issuer may have different types of debt, with different maturities and credit quality. I would urge anyone who is not familiar with the fixed income market to discuss one's goals with a professional before investing.

Personally, and noting that I am not a financial adviser and am not providing advice to anyone, I went long many more bonds than before last October and November (as discussed more than once from that period onward), going from about a 33% allocation to more like 90%. This has come down to about 70%, but at the same time that I reallocated partially back to stocks, I also began increasing duration. The reasoning was and is two-fold. One is my fear of yield simply vanishing in the US, as it has in the EU and Japan. The other is the more speculative thought that the 30-year yield appears to be either drifting or perhaps plunging back to the 2.1% level it reached in 2016, and that if the global economy worsens, it could easily trade below 2%. So there could be capital gains potential from the long bond.

What about stocks for income in the current environment?

Yes, I think this is very reasonable, at least from a US perspective, where I perceive the banking system as safe and sound. Therefore, I do not expect another "great" recession that could destroy businesses and dividend streams that appear sound. As one basic example, Con Ed (ED), in my opinion the most bond-like of all US utilities, tends to trade a little over 1.4X the yield of the 10-year Treasury note. With that at 2.10% as I write this on Sunday night, that would put the equilibrium yield on ED at around 2.95%. However, ED closed Friday at $88.54, with a current yield of 3.37%. Thus ED could appreciate another about 11% just to get to that theoretical fair value, or at least fair trading value, level. Of course, that would a simple one-time gain for a long-term asset, but if ED's dividend rises annually as usual (at 3% per year), and especially if the 10-year bond rate drops well below 2% as it did in 2012 and 2016, ED and by extension most other utility stocks could continue generating significantly positive total returns.

A typical electric utility trades around 20X earnings. That's expensive given slow or even no growth ahead, and it may be that cheaper stocks will provide superior total returns over time, but the cheaper sectors may be fundamentally riskier.

Thus I would consider ED and a few other top-tier utilities as bond-like, but the more one gets exposure to riskier stocks that are not local monopolies, the less bond-like the investments become. If the US and global economies are cycling down and not ready to turn up, a hunt for yield may ignore less safe names for some time to come.

Risks to fixed-income investing

All investing involves risk. Bonds have default and inflation risk. Stocks that are bought for income have their own risks. Please be careful and knowledgeable before taking on risk.

Concluding comments - a risk-on move into bonds?

The charts above show that the first half of 2016 was marked by rising speculative sentiment into bonds, which drove yields on the 10-year T-note below 1.4% and on the 30-year bond to 2.1%. I recall Jim Cramer and an analyst or two pumping bonds in the January-February time frame, so they were right for several months. This has not happened at this point, but the rising speculative net long position in the futures market, and the weakening inflation numbers and outlook, suggest that this mid-stage bond bull market may continue recruiting fresh bulls with fresh money.

There are lots of reasons for bull markets, which may eventually go to excess. There is the famous FOMO, or fear of missing out, which we see in tech and biotech periodically. Those are sort of "fun" investing themes.

More serious, though, and I think ultimately more powerful, is the hunger for a safe, positive return on one's savings. Financially speaking, there may well be no hunger as powerful as yield hunger. And with investors in the US increasingly either retired or semi-retired, and much of the institutional money devoted either to funding pensions for future retirees or meeting obligations of insurance companies, we may have another 2016-like set-up to scramble into bonds to gain some yield with safety. Given where yields are in the eurozone, Japan, the UK and now even Australia, a fear-driven hunt to lock up yield in the US could be building. (See, among other sources, Bloomberg's web site for these yields).

It would be nice to know the future, but none of us do. So the thesis of this article for a potential further meaningful move in bond prices is very much up in the air.

The FOMC meets this coming week, and the meeting may be "live" regarding a change in monetary policy, in my humble opinion.

I hope the points and thoughts provided herein have been of some interest to you, either as an individual investor or as an investment professional.

Thanks for reading and sharing any comments you wish to contribute.

Submitted Sunday night, 10-year T-note yield 2.10%, S&P futures 2,898.

Disclosure: I am/we are long TLT, ED, DE, CAT. 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.