The Bull Market In U.S. Treasury Bonds Is Not Over

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Includes: EDV, SHY, TLH, TLT, ZROZ
by: EB Investor
Summary

Previously, I predicted we would see a fall in long-term Treasury rates that would send the 30-year to 2%.

The global economy continues to slow, and dangerous clouds are on the horizon.

Now that we have seen 2% on the 30-year, where does it go from here?

Introduction

There is no alternative is what they told us. You must own stocks, after all, the economy is ripping higher, and Treasury bonds are junk. This is the mantra used by many financial pundits to get people to buy more and more stocks. Followers of mine know that I have been quite a contrarian, calling for investors to ignore the crowd, and trust their savings on long-term US Treasury securities, which have a guaranteed rate of return when held to maturity. I did so, here, and here, and in many of my pieces on SA. Year to date, 30-year zeroes are up nearly 30% vs. around 17% for the S&P 500 index.

The volatility of recent weeks, is, in my view, a prelude, to what is to come in these highly overbought and overvalued markets. We see this in the precipitous drop of bond yields, especially at the long end, where the 30-year bond yield has fallen from 3.02% on 3/19 to 1.98% on 8/15. That is a startling 34% move for Treasury investors. I have called multiple times for the 30-year Treasury bond to fall to 2%, and now that it has, it begs the question, where do we go from here?

I believe there is enough evidence to continue with my bullish thesis that we have further to go in this long-term Treasury bull market. As a result, I would not be surprised to see yields back up a bit here, before resuming their trend lower still. My thesis on still lower rates is the result of a number of global economic factors.

Political Instability

The unique nature of the threats we are currently facing combined with the time in history with which they are taking place makes this an extraordinarily risky period of time. From a continuing trade war, complicated by advancing instability in Hong Kong, a no-deal Brexit hanging overhead, multiple places in the world that are on the brink of War, and global deflationary pressure pushing the developed world closer and closer to the brink of a deflationary debt spiral, I believe this is a time for prudence unlike any other.

Legendary macro investor Raoul Pal, recently stated that: "We are at the most important juncture in FX markets in my entire 30-year career. The dollar appears at risk of an uncontrolled rise." David Rosenberg, chief economist with Gluskin Sheff + Associates Inc., recently stated these are historic and dangerous times, as he discussed the $246 Trillion debt bubble and a return to many of the themes characterizing the 1930s.

We have long duration yields going negative, as discussed above. Debt dynamics are very unstable and likely why interest rates have to go down - but if they are negative, how do assets with cash-flow streams get valued? The distortions are wild. All the while, gold prices have broken out in recent months in all currency terms and central banks are adding bullion to their reserves.

And we have a Fed that's doing little more than sow confusion. Fed chair Jerome Powell did a "pivot" with his messaging as long ago as January, but didn't start to act until July. After sounding very dovish at his semi-annual congressional testimony, he walked that sentiment back at the following meeting, saying this wasn't going to be an easing cycle. Why on Earth would he say that? Meanwhile, we have had at least one dissent at each of the past two Federal Open Market Committee meetings, and half of the central bank is dovish and half is hawkish. We have a Fed chair who seems to change his mind constantly and who also is being badgered by U.S. President Donald Trump relentlessly.

This is also a President who has attempted to exert pressure on the Fed right out in the open, and who has blatantly attempted to verbally weaken the U.S. dollar, which makes no sense considering he simultaneously jeopardizes its status as the world's reserve currency. Beyond the deep social and political divisions in the U.S., we have the rising tide of nationalism and protectionism.

What we took for granted in the post-Marshall Plan/Bretton Woods experience was the unusually high degree of world co-ordination and integration. It wasn't perfect, but it engineered an unprecedented period of global ‎stability. And unless somehow the political leadership vacuum is filled, and filled fast, we are on a slippery slope. The gains of the past 70 years, in which the world became smaller and worked together to make it a better place, are at risk. It was an era of relative stability that we all know, having lived it. But keep in mind it was also a grand experiment - and now the ugliness of hate, blame, mistruths, nationalism and populism have staged a revival. Mr. Trump, Mr. Modi and Britain's Boris Johnson are symbols of this, not the cause.

To cap off, look at all the information at our disposal. Gold prices surging. Bond yields plunging. Central banks in a confused state. The breakdown of the world order. Here we have a trade and currency war going on between the world's two dominant powers - with no end-game in sight.

Think about what I am describing - gold soaring, bonds rallying sharply, an equity market rolling off the highs, deepening racism, and a tariff and currency war.

This sounds a lot like the 1930s to me."

Debt Burdens Are Growing

This is all the more compounded by the increasing debt burdens in the developed world. The US currently sits at over 370% of aggregate debt to GDP. Debt burdens are growing around the world, and there is no indication that they will be curbed any time soon. The US debt situation continues to worsen, as consumer debt soars, along with the national debt and corporate debt. The US consumer continues to spend on credit. U.S. consumer debt has risen to levels that exceeded the 2008 financial crisis.

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Corporate debt also continues to soar, as companies race to take on more and more low interest rate debt and hold on to their cash, eschewing capital spending.

CapEx Down

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US Corporate Debt Levels

Corporate debt levels are soaring, and there is evidence that leveraged loans are one of the most alarming risks in the economy, that few are discussing.

Risks of Recession Rising

I believe we have seen the peak in 30-year bond yields as well as a host of positive economic data points. It is my contention that recession is far closer now than most believe on Wall Street. Much of the data that I keep on my dashboard, is moving lower, in some cases drastically so. Commodity deflation continues to put downward pressure on prices, leading to severe risks in the energy sector, which could very well spark a serious default in the corporate debt market. A wave of corporate credit maturities will have to be rolled over in the next couple of years. How many of those that are currently rated BBB will be downgraded to junk status? This risk has been discussed at length and dismissed. The critics contend debt levels are high but not in relation to income to service them. I demur. Evidence is showing the increasing pressure of over indebtedness on the corporate sector, with bankruptcies increasing markedly.

Why Debt Burdens Matter

Fisher's equation of exchange tells us that M=the Supply of money and V=the velocity of money, and we can calculate GDP=M*V. With velocity at a low not seen since 1949 and continuing to fall, the trend for lower and lower GDP remains intact in the U.S., despite recent gains from the sugar high of fiscal policy developments such as the tax bill. In reality, the tax bill has increased overall deficit spending, as inflows have failed to meet the governments outlays, as we approach deficits of $1 Trillion, as this GOP White House departs from traditional fiscal conservatism. In addition, the nation's debt burdens continue to grow at both the national and household level. Aggregate debt sits at 370% of GDP and rising.

Academic research is very clear that growing debt burdens lead to lower and lower levels of GDP growth that can be achieved. I want to provide readers with five studies, followed by the conclusions of these researchers, as it is integral to the overall case we will explore here about the negative effect of debt on GDP growth:

In 2010, Carmen M. Reinhart and Kenneth S. Rogoff, concluded in Growth in a Time of Debt that:

Across both advanced countries and emerging markets, high debt/GDP levels (90 percent and above) are associated with notably lower growth outcomes."(p.577)

Reinhart and Rogoff, along with Vincent R. Reinhart, authored Debt Overhangs: Past and Present - Post 1800 Episodes Characterized by Public Debt to GDP Levels Exceeding 90% for at Least Five Years, in which they state:

Consistent with Reinhart and Rogoff (2010) and other more recent research, we find that public debt overhang episodes are associated with growth over one percent lower than during other periods. Perhaps the most striking new finding here is the duration of the average debt overhang episode. Among the 26 episodes we identify, 20 lasted more than a decade. Five of the six shorter episodes were immediately after World Wars I and II. Across all 26 cases, the average duration in years is about 23 years. The long duration belies the view that the correlation is caused mainly by debt buildups during business cycle recessions. The long duration also implies that cumulative shortfall in output from debt overhang is potentially massive." (p. 1)

In The Real Effects of Debt, authors Stephen G. Cecchetti, M.S. Mohanty, and Fabrizio Zampolli conclude:

Our examination of debt and economic activity in industrial countries leads us to conclude that there is a clear linkage: high debt is bad for growth. When public debt is in a range of 85% of GDP, further increases in debt may begin to have a significant impact on growth: specifically, a further 10 percentage point increase reduces trend growth by more than one tenth of 1 percentage point." (p.21)

Cristina Checherita and Philipp Rother's piece, The Impact of High and Growing Government Debt on Economic Growth, An Empirical Investigation for The Euro Area, states:

on average for the 12-euro area countries, government debt-to-GDP ratios above such threshold would have a negative effect on economic growth. Confidence intervals for the debt turning point suggest that the negative growth effect of high debt may start already from levels of around 70-80% of GDP, which calls for even more prudent indebtedness policies. We also find evidence that the annual change of the public debt ratio and the budget deficit to-GDP ratio are negatively and linearly associated with per-capita GDP growth." (p.6)

They further conclude:

a higher public debt-to-GDP ratio is associated, on average, with lower long-term growth rates at debt levels above the range of 90-100% of GDP. The long-term perspective is reinforced by the evidence of a similar impact of the public debt on the potential/trend GDP growth rate."(p.22)

Andreas Bergh and Magnus Henrekson's paper Government Size and Growth: A Survey and Interpretation of the Evidence, found that as government size increases, GDP growth declines.

Debt acts like an albatross around the neck of a nation, choking off economic growth. What makes matters worse is that the debt is growing. More and more people are financing cars, depreciable assets, with longer and longer terms. Taking on more and more debt. Student loans are ballooning, putting the financial security of an entire generation in jeopardy. Credit card balances are growing, but wages are growing only modestly when we take out inflation and the increased debt burdens on households, many Americans continue to fall behind.

Portfolio Strategy

So, what does all this mean for you, the investor? I believe that long-term zero coupon U.S. Treasury bonds offer investors value, even at today's yields. With a likely trend in rates that takes us to ever lower yields, in accordance with rates in other parts of the world, my new target in the 30-year is to see 1%, or below, and frankly, I think we could very well see the 30 in negative territory eventually.

I also caution investors that the short term could very well see 30-year Treasury bonds fall as rates rise a bit off of these very low levels, as we are seeing today. As you can see in the chart below, every sharp move up in the 30-year market has been followed by a sharp sell off, while also maintaining the long-term trend higher, as rates grind lower. I do not see why this time is any different. Long-term investors who see the 30-year as a store of value in a world increasingly made up of assets with negative yields would be wise to vary their duration positioning across the curve. By no means am I selling 30s here, instead using excess profits on trading gains, to buy 2-year paper.

Conclusion

While I do believe 30s have value, even today, I also see tremendous value in other parts of the yield curve. If we are indeed entering a declining rate cycle by the Federal Reserve, then it makes sense to also hold a sizable portion in the 2-year, which is mathematically correlated with actions taken by the Fed. Currently, sitting at 1.48%, 2-year investors may have the most to gain, in the shorter run, as I expect the Fed to eventually bring us back to the zero lower bound. Indeed negative rates may be in our future, as I indicated in my piece from 2017, entitled "U.S Bond Yields May Go Negative." If that is the case, then we have quite a bit further to go in this bond bull market. Bottom line: Long 30 and 2-year zero coupon US Treasury bonds, long the US dollar, and long gold.

Disclosure: I am/we are long US TREASURY BONDS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor. This article does not constitute tax advice. Every investor should consult their tax advisor or CPA before acting on any information contained herein.