The bull market in bonds still has legs
Is the thirty-seven year bull market in US Treasury notes dead?
Yields to maturity on 10-year US Treasury notes are now at their highest level since April 2011.
The current yield to maturity is 3.21%, a significant rise from 1.387%, which the market touched on July 7, 2016 in the immediate aftermath of Brexit and a flight to quality in US dollars and US Treasury notes.
The US Treasury market is volatile with lots of rallies and reversals, but the overall trend since 2016 has been higher yields and lower prices.
The consensus of opinion is that the bull market that began in 1981 is finally over, and a new bear market with higher yields and losses for bondholders has begun.
Everyone from bond guru Bill Gross to bond king Jeff Gundlach is warning that the bear has finally arrived.
‘It’s different this time’
In effect, the bond gurus and professional traders are betting that it’s different this time.
They’re betting that the Trump economic changes and tax cuts have produced sustainable trend growth, that tight labour markets portend higher inflation, and that foreign investors are dumping US Treasuries in anticipation of this inflation.
In fact, there’s good evidence that every one of these assumptions is false.
Growth in the second quarter of 2018 and forecasts for third quarter growth are solid, but there’s good reason to believe that these conditions are temporary responses to the tax cut and will not be sustained into early 2019.
In this political environment, you can only cut taxes once; there won’t be another big tax windfall in 2019 to keep this game going.
There’s also no evidence that labour markets are tight enough to cause inflation.
Statistics, damn lies, and statistics
The current 3.7% unemployment rate ignores that tight labour markets don’t cause inflation.
It also ignores the fact that among the 62.7% labour force participation rate – near the lowest in decades – there are ten million able-bodied adults between the ages of 25-54 who are out of the workforce and not counted as ‘unemployed’.
In addition, there are millions more working part-time jobs who would prefer full-time employment.
Once the employment figures are adjusted for involuntary part-time workers and discouraged workers, the actual unemployment rate is close to 10%, which is a depression-level rate.
Labour markets are not tight at all (except by using cherry-picked government metrics) and therefore, there’s no reason to expect inflation.
Finally, the evidence that foreign investors are ‘dumping’ US Treasury securities is overstated.
Russia is getting out of US Treasuries, but other countries are picking up the slack and China is holding steady.
In any case, there is ample appetite among US banks to buy US Treasuries so any foreign selling can be readily absorbed.
With these caveats in mind, what is the outlook for Treasury prices?
The single most important factor in the analysis is that US Treasury notes have traded within a range of 1.4% to 3.9% for the past ten years.
Each time yields get too high, the economy slows and yields collapse. Each time yields get too low, the economy gets a boost and yields rise again.
Apart from a few good quarters of growth – which we also saw several times during the Obama years – there’s no reason to believe the US economy has entered a phase of strong self-sustaining growth of the kind that will lead to inflation and higher yields.
Investors turn to bonds in a panic
Productivity is low, labour force participation is low, foreign competition is stiff and the new trade war acts as a break on growth.
These headwinds are the same ones we’ve been facing for ten years, and there’s no sign they’re abating.
The chart below is also highly revealing.
It shows that investor cash balances are at the lowest levels in thirteen years, even lower than the levels at the tail end of the 2002-2007 investment boom prior to the panic.
This tells us, investor allocations to cash are the lowest in over ten years.
Lower than the levels immediately preceding the financial panic of 2007-2009.
Investors who lose money on short positions in US Treasuries will engage in frantic short-covering to mitigate losses and conserve cash.
This buying will propel a rally.
With cash levels this low, investors cannot afford large capital losses. In effect, investors have bet the ranch on higher US stock and corporate bond prices.
At the first hint of market declines, they will pile into perceived safe havens such as cash and US Treasuries to preserve capital.
This will give added impetus to the coming bond market rally.
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.
All the best,