- As expected, we have seen an acceleration in yields due to rising inflationary pressures which have pushed bonds lower.
- Evidence suggests that the Treasury bond market (and deficit) is almost entirely supported by the Federal Reserve and U.S commercial banks - the latter's support is waning though.
- Low bond yields beget high downside risk due to convexity and duration. BND's duration remains high despite the recent decline.
- Inflation may continue to rise much higher due to the lag between Fed policy and inflation as well as the growing wage-price spiral.
- The Treasury bond market may see short-term respite if equities decline as I expect, but this would be unlikely to last long.
One of the key trends in 2021 has been the ongoing decline in the bond market. Long-term rates have been on an aggressive rise as both the yield curve and inflation outlook rise together. This has made the beginning of 2021 one of the worst for bonds in decades. Most bonds peaked in early April of last year shortly after I wrote "BND: Don't Be The Federal Reserve's Mark" which described my bearish view on the popular bond ETF (NASDAQ:BND).
Indeed, I have warned about the bond market for quite some time so this crash was not unexpected. The primary reasons for my bearish view were rising future inflationary pressures due to the U.S dollar's decline, the fact that low bond yields beget higher downside risks (i.e. convexity/duration), and that bonds were only rising due to the artificial and temporary demand supplied by the Federal Reserve.
Today, most of those views are playing out in reality. Inflation expectations are on the rise and the slowdown in the Fed's purchase rate of bonds has led to poor long-term bond auctions. Based on the data, it seems clear that the situation in the bond market (corporate and government) is intimately tied to the U.S banking system today.
This is recently described in-depth in "XLF: Not All Is As It Seems For The Banking System" which details the fact that net Treasury bond purchases over the past year have been almost entirely made by the Federal Reserve and U.S banks (which have been directly encouraged to buy bonds in order to aid deficit expansion). More is explained in the article, but is perhaps best summarized as "banks' and the monetary system's increasing dependence on the U.S. fiscal deficit and Federal Reserve may prove catastrophic".
If this situation ends in some sort of monetary catastrophe, it would likely begin in the bond market and then reach the banking system. Quite frankly, the recent decline in bonds may only be the beginning of this potential event. Let's take a closer look.
Interest Rates Are Rising Across the Board
The value of BND is inversely correlated to long-term interest rates considering its effective maturity is 8.5 years. Nearly two-thirds of the fund is invested in government bonds while the remaining portion is in investment-grade corporate bonds. The spread between these corporate and government bonds is usually very low so they are all closely tied to Treasury bond yields.
The top three metrics I use to analyze the bond market have all seen a material rise. See below:
The purple line above represents the yield curve or the difference between the yields of the 10 and 2-year Treasury bonds. I generally view this metric as a gauge of expected future real economic growth - though it is firmly correlated with the current permanent unemployment rate (high unemployment today implies high economic rebound/growth 2 years from now).
The yellow line above represents the future expected inflation rate measured as the difference between the 10-year Treasury bond and 10-year inflation-indexed Treasury bond. This metric has risen dramatically due to the many inflationary forces impacting the market.
The blue line represents the 10-year inflation-indexed Treasury bond which is otherwise known as the real yield since these bonds pay the annual CPI growth plus a yield (which is currently negative).
Overall, it seems that the slight rise in real yields is ending which is sensible considering the small bounce in the dollar. The small rise in real yields has been the primary negative factor for gold over the past six months (see: "Everything You Need To Know About Gold In 2021") so, if a reversal occurs as I expect, gold may soon see another wave higher. It does not seem that the trend toward higher inflation breakeven rates or a sharper yield curve will end soon (unless the Fed pursues curve-control for the latter).
So far, we have not seen a spike in corporate bond yield spreads. In fact, the spread between investment-grade corporate bonds and Treasury bonds has declined to pre-COVID levels. Considering corporate solvency risks are materially higher than they were then, this may actually be due to the very poor private appetite for Treasury bonds or Q.E policies. That said, as investors reconsider solvency risks in corporate bonds, we may see this spread return to normal which would lead to slight declines for BND. If there is another liquidity event in the corporate bond market as there was last March (where BND fell 7% in a matter of days), then BND could see a rapid decline as its corporate bonds are repriced.
How Interest Rate Pressures Impact BND
Over the coming years, rising inflation appears to be the dominant negative factor facing the bond market. Inflation is rising in what "should" be a deflationary environment due to still-heightened unemployment. However, this inflation is backed by "wage-push" factors whereby job quits and openings are at peak levels while joblessness is high. In other words, the appetite for working at today's wages is low and wages will likely rise and cause a "wage-price spiral" (high costs beget higher wages which beget higher costs due to supply constraints). A similar situation occurred during the 1970s and led to a roughly 50% decline in the inflation-adjusted value of the 10-year Treasury bond by 1981.
In my view, the situation going forward could prove deadlier for bonds considering interest rates are lower today which means "duration risk" is higher. In regards to BND, its duration today implies a 1% rise in rates/inflation should bring the fund's value 6.6% lower. A 5% rise should bring BND about 33% lower but, of course, the true value would be further eroded after accounting for inflation. While such a rise in yields has not been seen for a few decades, it is not unprecedented and today's situation implies an even larger increase could be in store over the coming years. In compensation for this large risk, BND's investors are rewarded with a 1.4% yield which truly means -1% return after inflation and perhaps less after taxes.
The Federal Reserve has no plans to hike rates despite inflation being "above target." Considering it took a decade for low rates to spur an inflationary spike, a future rise in short-term rates may not stop rising inflation. Of course, a large increase in inflation (not necessarily hyperinflation) is probably the only way the effective U.S fiscal debt can be reduced to a payable level.
The Bottom Line
My long-term outlook for BND remains as bearish as it was last July. Truly, I am more bearish than I was then since it seems the U.S government has become inebriated by a 400-600% increase in deficit spending from normal levels over the past decade. In my opinion, the appetite for deficit spending has reached such an extreme that a credit rating downgrade is inevitable. Bonds may see short-term respite if equities decline as I expect over the coming months, but this would only be relevant to those looking to actively trade.
By any normal metric, the U.S government should have a much lower credit rating, but historical attempts to judge the U.S government's credit by "normal" standards have been politically futile. While the U.S government may never default on its debt, the Fed's current process of creating new money to buy Treasury bonds (and thereby create inflation) seems to be of little real difference to bond investors and should therefore be priced into yields.
The bottom line is that I believe BND and virtually all bonds should be avoided. Quite frankly, it seems that higher-yield bonds may actually offer a better risk-reward profile considering they have less duration/convexity risk with rising inflation. Even still, we are in a period where not all is as it seems and significant monetary policies seem to be obfuscating economic reality - potentially misleading investors and analysts into underestimating the risk environment.
Given this, I personally am avoiding all fixed-income and most equities. That said, if real rates drop while inflation rises, then gold and bonds should finally disconnect in a bullish manner for gold (and most commodities). Precious metals may be a safer alternative to bonds today.
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