Bond bull market set to return with a vengeance
A bond bull market is about to come back strong as the Fed once again makes a policy mistake.
I recently discussed the soaring bond yields, noting that such events have already led to more undesirable economic and commercial results.
“As shown below, the spike in 2-year bond yields is unprecedented. Historically, such spikes in short-term yields coincide with recessions or market events. With yields now 4 standard deviations above above their 52-week moving average, such has traditionally denoted performance peaks before.”
The graph is updated to the current performance levels.
What’s important about the 2-year treasury yield is that it maintains a very high correlation with the fed funds rate. As shown below, the current surge in the 2-year yield is leading the Federal Reserve rate, suggesting that the Central Bank is way behind the rate hike curve.
The importance of these two graphs should not be quickly dismissed.
The Federal Reserve has just begun its rate hike campaign to tighten monetary policy. However, the bond market is already rapidly tightening policy, which will slow consumption by increasing borrowing costs. As noted previously:
“People don’t buy houses or cars. They buy payments. Payments are a function of interest rates, and when interest rates go up, lending activity goes down as payments exceed the affordability. In an economy where 70% of Americans have little savings, more payments have a significant impact on family budgets. This is a critical point. Higher interest rates create “demand destruction “.
This is a crucial point.
Long-term returns at critical levels
The US economy is more heavily indebted today than at any time in human history. Since 1980, debt levels have risen steadily to close the gap between income and the desired standard of living. Larger homes, televisions, computers, etc. all needed ever-cheaper debt to fund it all.
The chart below shows the inflation-adjusted median standard of living and the difference between real disposable income (DPI) and the debt needed to support it. From 1990, the gap between the DPI and the cost of living became negative, leading to an increase in the use of debt. In 2009, DPI alone could no longer sustain living standards without resorting to debt. Today, he needs nearly $6,400 a year in debt to maintain his current standard of living.
This is why, with the heavy need for cheap debt to support living standards, sharp rate hikes have an almost immediate impact on economic activity.
From a technical perspective, we can analyze the levels where previous rate hikes have impacted economic activity. The current surge in bond yields has taken 10-year yields to extreme overbought levels. As with the 2-year rate, the 10-year rate is now 4 standard deviations above its 52-week moving average. It is also approaching the top of the 1980 long-term downtrend channel.
At 2.5%-3% on the 10-year Treasury yield, the economy will begin to feel the effects of reduced consumption.
Although rates may rise temporarily, there is a time when “something breaks” economically speaking, and deflationary pressures will reassert themselves.
No one wants to buy things in a bear market
Currently the link “bear market” at his best. Interestingly, just as is the case with a bear market in stocks when asset prices are wildly beaten, no one wants to own them. However, this is historically exactly when you want to buy assets.
Of course, the most difficult thing to do in the financial markets is to buy “when there is blood in the streets.”
As shown in the table below, the current “bond bear market” is one of the longest and deepest draws ever recorded.
Of course, we must remember that following each of these precedents “bear markets” was a “bull market” into bonds as the cycle reversed.
This time will probably be no different.
As the Fed raises rates and reduces its monetary support to financial markets, money will eventually see the safety of the highest quality collateral, which is Treasuries. As we noted earlier:
“Empirically, long bond yields faded each time we approached the end of a QE program. Will this time be different? I doubt. -Andreas Steno Larsen
The reason for this is that when the Fed removes market liquidity (QE), market participants switch from “at risk” positioning at “at risk”. Indeed, the reversal of QE coincides with weaker stock markets.
Although buying bonds today may still have some “pain” in them, we are probably closer to a significant buying opportunity than not.
More importantly, if we are correct, the next bond bull market will likely outperform equities and inflation-linked trades over the next 12 months.
Such a result would not be the first time this had happened.
Of course, buying bonds when no one else wants them is a difficult thing to do.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.