The Bull Market That Won’t Die
Investors have been hearing for years that “interest rates are near all-time lows,” and “rates have nowhere to go but up,” and finally, that “the bond bear market is right around the corner.”
These warnings have come from notable bond gurus including Bill Gross, Jeff Gundlach and PIMCO’s Chief Investment Officer Dan Ivascyn.
Investors are told that the time has come to dump bonds, short them if you can, and brace for much higher interest rates.
There’s only one problem with these warnings. The bond gurus have been dead wrong for years, and they’re wrong again now. Rates are going lower, and the bond market rally that began in 1981 has further to run. The bull market still has legs.
To paraphrase Mark Twain, reports of the death of the bond market rally have been “greatly exaggerated.”
The key is to spot the inflection points in each bear move and buy the bonds in time to reap huge gains in the next rally.
That’s where the market is now, at an inflection point. Investors who ignore the bear market mantra and buy bonds at these levels stand to make enormous gains in the coming rally.
“The Much Feared Bond Bear Market Never Materializes”
Let’s look at the record. The 10-year U.S. Treasury Note had a yield-to-maturity of 3.64% on February 11, 2011. That soon fell to 1.83% by September 23, 2011. Then the yield spiked to 2.23% on March 16, 2012. It fell back again to 1.46% on June 1, 2012.
Yields spiked again to 3.0% on December 27, 2013. Then yields fell back to 1.68% by January 30, 2015. And, so it continued through 2016 and 2017. Yields staged one last major back-up reaching 3.22% on October 5, 2018, before crashing once again to 0.54% on July 31, 2020.
Notice the pattern? Yes, yields are back up with some regularity. But they have never broken through the 3.25% level in nine years. The much feared bond bear market never materializes.
When yields get above 3%, the economy stalls out, disinflation takes over, the Fed panics and either “pauses” rate hikes or cuts rates resulting in yields coming back down to earth. Every time yields fall, bond investors make huge capital gains.
That’s exactly why the opportunity to go long Treasuries is so attractive. With all of the big players (hedge funds, banks, wealth managers) leaning on one side of the boat, it only takes a small perturbation causing lower yields and higher prices to trigger a massive short-covering rally, where these short investors scramble to exit their positions and buy bonds to cut their losses.
That’s not all. This technical history exhibits a pattern called “lower lows.” The rate spikes run out of steam around 3%, but each rate collapse goes lower than the one before. The history of rate bottoms is 1.46% on June 1, 2012, 1.36% on July 8, 2016, and the recent low of 0.54% on July 31, 2020.
Every time the bears say yields are going to the moon, they crash to a new low. That means bigger gains for investors.
Basic Bond Math
A bit of bond math is always helpful in these discussions since it’s counterintuitive for many investors. Yields and prices move in opposite directions. When bond yields go up, bond prices go down. When bond yields go down, bond prices go up.
Investors hoping for higher yields may not realize that the bond prices in their portfolio go down when that happens.
The best trading strategy is to buy a bond just when yields spike, and then hold it as yields fall back down to earth. That way, you keep the high yield on your bond and accrue huge capital gains as market yields decline. You can hold the bond to maturity, of course, but you can also sell it for a gain, move to the sidelines with cash and buy a new bond when yields get toppy again. Wash, rinse and repeat.
There’s another bit of bond math that is not intuitive to most investors. It’s called convexity or duration. In plain English, it means that as interest rates get lower, the capital gains get larger for each basis point decline in rates.
As an example, rates can decline from 3.50% to 3.25%. They can also decline from 1.00% to 0.75%. In each case, interest rates dropped by the same 0.25%. And, in each case, an outstanding bond would realize a capital gain.
But, the capital gain is larger in the second case than the first. Not all interest rate declines are created equal. Gains are bigger when rates are lower. Right now, rates are quite low, so the potential for capital gains is spectacular.
But, with rates so low already, what is the potential for rates to fall even more?
Rates on 10-year Treasuries rose from 0.513% on August 4 to 0.848% on October 22. Rates are 0.768% as of today. Right now, my models are telling me that bond yields will continue to fall, which means that bond prices will continue to rise.
Don’t Buy Into the Consensus
What’s been driving this increase in rates? The answer is simple. Markets expect a new deficit spending stimulus package from Congress. The package is still under negotiation, but the expectation is that it will be around $2 trillion, comparable to the $3 trillion of spending packages passed between March and June, during the worst stages of the pandemic.
Markets expect that this much new debt will flood the markets with new Treasury borrowings, which will drive bond prices lower. Markets also expect that this much stimulus will be inflationary because the Fed may have to monetize the new debt. The combination of more supply with a higher risk premium for inflation will result in much higher yields.
Both assumptions are probably wrong. The spending package depends on the election.
Democrats are confident that Joe Biden will win, so they are holding out, both to avoid giving Republicans a pre-election win and to get a better deal under President Biden.
Republicans take the opposite view and are holding out for a more conservative package under a reelected President Trump. The result is a stalemate.
My forecast is that Trump will win, and markets will be disappointed at the size (and spending priorities) of any package that results. This will cause rates to crash again.
Too Much Debt for Stimulus to Work
Even if a large spending package passes in the next few days or shortly after the election, it will not have the inflationary impact markets expect. Congress knows how to spend, but they do not know how to provide stimulus.
In fact, stimulus in the Keynesian sense is impossible when government debt levels are 130% of GDP. Research shows that any stimulus effect goes into reverse when debt-to-GDP levels pass 90%.
What you end up with is more spending, higher debt, but lower growth. Everyday Americans respond not by spending more but by saving more in anticipation of higher taxes or inflation down the road.
The short-term impact of that is not inflation, but disinflation or outright deflation. That means lower rates and bigger capital gains for Treasury bond investors.
As for rates being “low,” they’re not. It’s true that nominal interest rates (the kind you see on screens and TV) are near all-time lows. But real interest rates (nominal rates minus inflation) are quite high by historical standards. Real rates have to go much lower to help growth.
With inflation dropping, that means nominal rates have to go deeply negative in order to get real rates low enough to help. My forecast is for 10-year Treasury note rates to go to negative 0.50% or lower over the next year. That means large capital gains for investors in Treasury bonds.
Don’t go along with the crowd on this one. If you’re on the wrong side of this overcrowded trade, you could get trampled.
for The Daily Reckoning