I had some bullish economic thoughts last week. But I also embedded a warning about support for bonds being broken. Yields at the long end of the US Treasury curve are rising, potentially to the top of a range between 1.00% and 1.50% and that’s creating an ideal situation for US financials. But, it is toxic to long duration equity plays like tech stocks. The question is whether this is a head fake or a real move higher. Some thoughts below
Shades of 2018
Market conditions remind me of early 2018 when the Fed was embarking on a rate tightening cycle that took it to four hikes that year in an accelerated time table. It ended in tears with the Powell Pivot and eventually rate cuts after the fourth rate hike caused equity markets to tumble. But, the episode provides some useful talking points for today.
If you recall, everyone was talking about a bond bear market at the beginning of 2018. I have a number of posts from January and February 2018 on that theme from my now archived WordPress site highlighting how Jeffrey Gundlach, Bill Gross and Ray Dalio were all talking about rates going higher.
Dalio told Bloomberg’s Erik Schatzker at Davos 2018 that we were already in a bond bear market.
Gundlach was saying 3% was game over for the bond bull market.
Gundlach says getting above 2.63% on the 10-year would be a “big deal,” likely pushing the 10-year towards 3%.
“If you get above 3%, then it’s truly, truly game over for the ancient bond rally.” pic.twitter.com/o5UiiAAs3K
— Myles Udland (@MylesUdland) January 9, 2018
Bill Gross had Janus tweet for him about it.
Gross: Bond bear market confirmed today. 25 year long-term trendlines broken in 5yr and 10yr maturity Treasuries.
— Janus Henderson U.S. (@JHIAdvisorsUS) January 9, 2018
Gross even went so far as to say the bond bear market had begun 18 months prior in 2016.
Bonds, like men, are in a bear market. For both, it’s hard to say when it all began. There was no Helen Reddy “I Am Woman” moment back in June 2012, and then again in July 2016 when the 10 year Treasury double-bottomed at 1.45%, but then in retrospect it should have been obvious that for bonds, like men – “their time was up”. Eighteen months ago, it was obvious to most observers that the economy, measured by nominal GDP, was not going to go much lower than 3% and that the Fed was having second thoughts about quantitative easing. A 1.45% 10 year was at that time set up for perpetual QE and the possibility of a deflationary collapse in the economy. Neither condition prevailed, and so 1.45% for tens can legitimately be cited as the end of the bond bull market which began at 15.8% in 1981 and provided prescient portfolio managers with the potential for huge capital gains and the moniker of “total return”, which previously had been the sole bastion of stocks and real estate.
Even Sir Alan Greenspan got into the bond bear mix.
I am not convinced we are going to see a bond bear market, at least one that is long-lasting. And that’s because a bond bear market will necessarily negatively impact credit growth, precipitating a recession. This is negative for inflation and bullish for bonds. So while the initial move might be bearish, if it does indeed create crisis conditions, it will force yields lower, a lot lower.
I also noted the following:
We should expect higher rates to potentially add a measure of accelerant to the US economy as debtors pull forward their borrowing and the private sector becomes flush with interest income. Inflation could even surprise to the upside as this cycle reaches its end. This in turn will mean a tightening cycle that is more aggressive than anticipated and risks derailing the US economy in 2019 and beyond….
How the Bond Bear Thesis unravelled in 2018
As you know, I proved right and the other gentlemen were wrong. The accelerated hiking of the Fed was simply too much for markets to bear and things started going haywire in the Fall, ending in the steep market correction in December, the subsequent Powell Pivot and the rate reductions that followed.
Let’s remember that the 10-year did hit 3% as Gundlach warned. I wrote a post in October of that year on “Why the ten-year’s hitting 3.25% has spooked asset markets”. So, we did have a horrific bear steepening. It’s just that the steepening proved too much to bear. I ended that October 2018 post writing “In the meantime, watch for signals that we are moving to four rate hikes in 2019 in addition to four in 2018. This may be enough to push us into distress. But, then again, it may not be. It’s just too early to tell.”
It did push us into distress. And the whole thing unravelled.
There were others who were saying the same thing like Gary Shilling, by the way. Albert Edwards of Soc Gen is one. I wrote about his view in February 2018:
A couple of weeks ago I mentioned Albert Edwards’ bullish views on US Treasuries. The interesting bit was his prediction that 10-year Treasury rates would exceed 3% before long. He is basically saying, ‘first the meltdown, then the melt-up’.
How about now?
We face a similar situation to 2018 now. There are a few key differences though.
One is that the Fed isn’t engineering the sell off in bonds. The market is taking yields higher. That means this isn’t a bear steepener when both short and long rates are going higher but long rates more so. We have short rates pinned at zero by the Fed and the curve steepening without the Fed’s actively signalling any forward guidance to encourage it. That tells you this is the market frontrunning the Fed based on expectations about real GDP growth or inflation or both. The market is essentially signalling concerns that nominal GDP is going higher and that yields need to move in that direction to either protect against inflation or because the Fed will act with a lag.
A second difference is that I am more concerned about inflation this time than I was last time. I don’t think it is a secular issue, but it could be a cyclical one. With commodity prices rising and pent-up demand potentially buoying prices further still once enough people are vaccinated, we could see an even steeper sell off in bonds as inflation expectations rise. I remember being less concerned about that in 2018.
And, of course, we are in the middle of an historic pandemic now. That’s totally different because it has the potential to alter consumption patterns in a meaningful way that causes financial distress and potentially leads to continued massive deficit spending.
My View
But, overall, the contours are the same. The US economy can’t handle higher yields. There is only so much steepening we can get before a couple of things occur – we break the junk bond and leveraged loan market or we break the equity market.
It’s not just that yields are low. It’s that spreads are also low too. High yield bond yields have been below 4%. Why not call it low yield bonds? More steepening means not just higher rates but also, likely, higher spreads too, a double whammy for high yield and leveraged loans. In a worst case scenario, we could be back to where we were in December 2018, with massive dislocations in that market. Those are markets that Jerome Powell knows well. And he knows the credit cycle usually leads. If you let this market fall apart, it would ripple through the economy and potentially kill the recovery. Powell won’t let that happen. Yield Curve Control is not out of the question.
Then there are equities. We saw what happened in December 2018. Equities went into a tailspin as Fed forward guidance told them the Fed was going to continue to keep hiking in 2019. This was after the market began 2018 expecting two rate hikes, though the Fed was saying three and ultimately delivered four. It was simply more than the market could bear.
Why? A large share of the market capitalization of US equities is in companies where the lion’s share of discounted cash flow value is backloaded. These are companies where you have to wait a long time before you see the cash flows that are discounted in the price. And the discounting is suspect because of Hyman Minsky’s two price system model of the economy. The longer a cycle continues, the less margin of error people make, not only with their leveraged bets as Minsky noted, but also in assessing the probability of larger future discounted cash flow streams from investments. Late in a cycle, all it takes is a spike in yields and that margin is wiped out.
This is where we are now. So, as with 2018, there is only so much higher rates can rise before it infects equities, high yield and leveraged loans. And that will force both market selloff, a deleveraging, and a curve flattening. Where that level is, I don’t know. Just as in 2018, it’s both the level and the pace of long-end rate acceleration that matters. We made it to 1.19% before we got jitters in January. Yesterday, we got to 1.30% and got jitters. It will be this way all the way along until people throw in the towel and say, “I’m not paying 40 times earnings for Apple with yields at this level.”
In the meantime, the rotation trade into areas impervious to rate increases and ones like financials that benefit makes sense. Financials are in and sectors like technology, where all of the supposed cash flow accrues in the future – I’m talking about you, Tesla – are out.