Bond-Market Bears Are Everywhere
A lot of people seem to think the bull run is over.
Bloomberg, April 26, 2018
Earlier this week, I posted this poll on Twitter:
30 year Bond bull market is over
— Barry Ritholtz (@ritholtz) April 23, 2018
The results surprised me, mainly because they were closer than I had expected. Despite the flirtation of 3 percent yields on the 10-year Treasury bond, many folks don’t believe the multi-decade run of lower interest rates has ended. 1
- Fixed-income investors want higher yields;
- Bonds offset equity volatility in a portfolio;
- Treasuries behave very differently from stocks;
- Interest rates reflect the state of the economy;
- Yield-curve inversions have been greatly exaggerated.
Let’s consider what each means:
No. 1: Yield. Buyers of Treasury bonds typically expect to receive a return on their capital in excess of inflation. (If they want capital gains from bonds, they should speak to someone like Howard Marks of Oaktree Capital Group about buying distressed fixed-income assets.) How they position themselves in the rising rate environment will determine how successful they will be…
As the Federal Reserve raises rates, the short end of the yield curve has risen, as one would expect. The long end of the yield curve has risen as well, perhaps on expectations of faster inflation. My question is: What will the real, inflation-adjusted yield of Treasuries be once the monetary tightening cycle is done? Will Treasuries offer protection from the loss of future purchasing power? The answer depends on so many factors that making accurate forecasts is basically impossible.
Those who have been complaining about low yields and financial repression need to find something new to whine about.
No. 2: Portfolio composition. As investors allocate money among different assets, they face a complex question: What sort of expected returns are you looking for, and what sort of risk and volatility are you willing to accept in the pursuit of that performance?
We know stocks are much more volatile than Treasuries and investment-grade corporate bonds. We also understand the impact of that volatility on investors’ ability to stay with whatever their financial plans are when markets turn into a carnival ride.
Here is an overlooked truth: The optimal portfolio isn’t the one that delivers the best performance. Rather, it is the one you can live with through the ups and downs of markets. We also know that stocks and bonds are not usually correlated, meaning they tend to be affected by different things and react accordingly. Having a ballast of quality bonds (investment-grade corporates, TIPS, and Treasuries) helps offset much of the volatility of equities, allowing investors to ride out the market’s gyrations.
No. 3: Bonds are different. Here is the thing about Treasuries: They don’t behave anything like equities. As my colleague Michael Batnick, research director at my firm, likes to say, “A bad year in bonds is a bad day in stocks” He cites this historical tidbit:
In January 1941, the 10-year treasury was yielding 1.95 percent; by September 1981 it was up to 15 percent. Over that time, 10-year bonds had nominal losses just 10 times, with the worst annual loss at 5 percent.
That is hardly the stuff nightmares are made of. Inflation, on the other hand, presents a completely different risk of reduced purchasing power. This is a much more significant concern to fixed-income investors.
No. 4: It’s all about the economy. Interest rates reflect a variety of factors: the economic cycle, the creditworthiness of lenders, inflation, demand for safe assets, and so on. But first and foremost, the state of the economy largely determines Fed actions and investor behavior and therefore rates. Unemployment has fallen to about 4 percent; many industries are finding shortages of skilled workers; wages have begun to tick higher. A huge (if unneeded) fiscal stimulus was just enacted. All of these point to rising interest rates and bond yields in the near future.
No. 5: Yield curve move. Tales of an inverted yield curve have been greatly exaggerated. A slowly rising rate cycle in the face of full employment and modest wage pressure isn’t the worst environment for fixed income. Add to that the Fed’s desire to get off of the emergency footing it adopted during the financial crisis, and the rise in yields above 3 percent looks rather measured and rational. A sign of Armageddon it isn’t.
Yes, yes, I know lots of new debt is going to be coming to market courtesy of that fiscal stimulus — it’s a $1 trillion tax cut to be funded via borrowing. But as I and many others have noted, there has been a global shortage of quality sovereign 2 debt. And, for better or worse, the U.S. is still the world’s best credit.
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1. One of the poll respondents suggested a choice “C” — I was guilty of bias in how I framed the question, and I plead guilty. “Interest rates are the level at which the economy can operate.” That’s a fair point, and another element for Treasury holders to consider.
2. Originally, “The Worldwide Deficit of High-Quality Debt.”
Originally Bond-Market Bears Are Everywhere
