The End of a Long Bull Market for Bonds
Much attention has been paid, in history and especially in recent years, to finding ways to spot, avoid, or bet on or against speculative bubbles, and, for policymakers and investors, how to spot them, if not far in advance, then at least before they burst.
The most obvious, latest major bubble to burst was the residential real estate market, and, secondarily, the commercial real estate market, in the United States and some other major developed markets such as the United Kingdom.
There is some dispute as to whether the coincident bull market in commodities was separate or connected to the real estate bubble, and whether or not it may have revived, as the economies of emerging industrial powers continue to consume ever-larger quantities of energy, materials and food.
Prior to the latest financial debacle, that of real estate, which has yet to be entirely solved and resolved, the next most obvious speculative bubble to have burst was the tech and Internet bubble, which hit its peak in early 2000. The Nasdaq Composite Index climbed over the 5,000 mark and has never come close to fully recovering, currently bouncing around half that level. Even the less-tech-heavy S&P 500 is still below its all-time high, hit around that time. It has been a lost decade for stock market investors in the United States.
On the other hand, those who invested in long-term government or high-grade commercial bonds have done very well over the past decade; in fact, albeit with some temporary downdrafts, they have been in a long bull market ever since 1981, when both long- and short-term interest rates peaked in all developed economies in the mid- to high-teens.
This has been the longest bull market in bonds in modern history, perhaps in all history. (The last one, starting in World War I and ending late in the Great Depression, needed that depression to make the investment pay off as well as it did, in real terms, as inflation was negative for most of that time.) No other investment class has had such a long run before a large crash or correction and then a resumption of its upward trajectory.
Also, unlike stocks or real estate, bonds cannot escalate to an always-higher, let alone infinite value; they are limited by the downward boundary of a minimum interest rate above zero, and by their maturity(ies).
It could be the case that bonds still have some room to outperform; long term, i.e., thirty-year, interest rates are still at or above the 3% level, and could go lower, particularly if the outlook for the U.S. or global economy continues to darken, inflation subsides, or the U.S. Federal Reserve Board or other central banks persist in growing the money supply and purchasing long-term bonds themselves, lowering their yields.
However, it is a cardinal rule of investing to not rely on an artificial situation or environment for too long, if at all, as circumstances could change swiftly, bringing massive losses to any strategy that is so dependent.
In the early part of this new century, the U.S. central bank, the Federal Reserve Board, in response to the recession brought about by the tech bust, and then the attacks of September 11th, 2001, maintained a policy of low short-term interest rates, which had the effect of tending to reduce long-term rates, as well. Then, when commodities prices rose and short-term rates along with them later in the last decade, the real estate bubble burst, and the Fed response was, again, to lower interest rates, yet not just substantially, but drastically, to close to zero, where they remain today.
The Fed, worried about the very weak state of not only the national economy, but home and commercial real estate prices, and the solvency of the banking system, plus the massive amounts of deficit financing of the federal and state governments, not only injected huge amounts of short-term credit, but also purchased long-term bonds of all kinds, principally U.S. Treasury Bonds and Notes, but not limited to those, as it also purchased mortgage-backed securities.
The intention of all this liquidity expansion was to counteract the contractionary effect of the dramatic fall in asset prices, and the accompanying fall in bank and bond market lending to the private sector. These operations were called ‘Quantiative Easing,’ in two stages, called ‘QE1,’ and ‘QE2,’ and a related, but different operation called ‘Operation Twist’ more recently.
Long-term yields have declined dramatically, which was the intention of the Fed. Corporations and some individuals have been able to borrow or refinance at attractive rates not seen in more than a generation. However, this has not been sufficient to revive home prices, roughly a quarter of which are less than the mortgages on them, or capital investment and hiring by businesses in the U.S., both of which were important goals of the Fed strategy and operations.
These liquidity expansion and bond-buying operations all have the effect of greatly increasing the money supply, which, some critics worry, ultimately will fuel inflation. Indeed, consumer price inflation, and commodity inflation have picked up, which is also directly related to the decline in the U.S. dollar against the currencies of its major trading partners.
Goods such as gold and crude oil, priced in dollars, have gone up by about three times their 2008 lows. Grain and mineral prices have also recovered most of their losses from their peaks in mid-2008. Most importantly, not only short-term interest rates, but long-term interest rates are now below the current rate of inflation, a condition which rarely persists for long, unless an economy remains stagnant, as Japan has largely been for the past twenty years.
It could very well be the case that the United States, indeed, will continue to remain mired in a low-growth slump with little employment or profit growth. In those conditions, credit demand by anyone else but the federal government will likely remain low, and so will profit growth.
While large government deficits would seem to argue against buying long-term bonds ordinarily, in such a dismal economic scenario, they could, to both individual and institutional investors, appear to be the best alternative out of all the available investment options: equities (stocks), real estate and bonds.
There is something else -- a perverse aspect of ever-lower interest rates which can have a pernicious aspect in causing the reinvestment in to long bonds to build on itself. A strange effect occurs the lower interest rates go, especially on the long end.
The ‘duration,’ a financial formula measure, gets larger and larger as interest rates decline, and, at very low interest rates, starts to approach the value of the remaining maturity of a bond, in years. For instance, the maturity of a thirty-year bond is, of course, thirty years, but the duration is somewhat less. A zero coupon, i.e. no interest bond, will have a duration that is exactly equal to its maturity. As the yield to maturity approaches zero, the duration will get higher and higher, approaching that of the bond’s maturity. This is crucial, because the gain or loss on a bond as interest rates change is directly dependent on its duration.
If a thirty-year bond has a duration of, say, twenty, a change in long-term rates of one percent will change the bond’s price by roughly twenty percent. That is a huge move for a bond price. While it may seem unlikely that long-term bond rates will decline by that amount in the next year or two, some investors may reason that they are more likely to head in that direction than that the stock or real estate markets will suddenly soar, especially given the current jittery environment and desultory outlook.
If interest rates come down by just another half percent or so, as they have during this year, 2011, they could easily make, with the coupon, a return in the double digits, which, on a risk adjusted basis, is far greater than they might get in other asset classes over the next two years, particularly if the United States must deal with many unpalatable choices in spending cuts and possible tax increases that, in the short term, could perpetuate the stagnation of the economy.
That, as sad as it sounds, is the main bond bull story: the scenario or rationale for not only retaining a substantial holding of long-term Treasuries, but perhaps going all in and making them the largest asset in mid-term outlook portfolio.
However, investors who are betting on that scenario, or who are merely complacent and content with their Treasury allotment may be deluding themselves, and endangering the wealth entrusted to them.
The Unites States is not Japan. It still has the largest, most technically inventive, diverse and dynamic economy in the world, and its most liquid and innovative financial markets, aside from its well-publicized and likely transitory political stasis, worker skills, and educational problems. There are already some signs of life in industry, if not real estate and construction, and employment growth is starting to pick up.
Corporate profit growth has been impressive, and some new investment and replacement investment will have to occur domestically; not everything can be done in foreign subsidiaries or by outsourcing. This investment has a very high multiplier effect when it happens, much more so than any sort of government stimulus. There is also a growing political consensus for radical tax reform, including lower corporate income tax rates, which could greatly improve the investment climate.
The U.S. economy, despite a major trading partner, the European Union’s likely descent into a new recession, appears set to grow by around 2% in real terms both this year and next. That is not enough to reduce unemployment significantly, but it is enough, along with moderate global growth, to maintain the current level of corporate profit growth.
The United States has three other things that militate against the ominous Japanese precedent: higher population growth, significant immigration, and a diverse culture still retaining many positive attributes of enterprise, independent thought, and creativity. There is a great ferment of new business ideas, new inventions and services, and opportunities that can be not only grasped, but created.
The sheer size and diversity of the U.S. economy itself is an opportunity. The United States will add about ninety million people in the next thirty years, a population the size of Germany, and will need expansion of utilities, pipelines, roads, airports, railroads, ports, and all manner of consumer and commercial goods and services. This will have to occur; it is merely being delayed now.
There is already a large amount of pent-up demand as individuals have added to their savings and shed some debt, and also on the part of companies that have, in an uncertain economy, and with political uncertainty as to how and by how much taxes could increase to start to address the massive public deficits and debt, avoided investing in expansion or renewal of facilities and equipment. There are already some signs of consumer pent-up demand starting to impact the economy. Retail sales have been robust thus far this year. Business spending could follow thereafter, as conditions show signs of improving.
That is the case for the real economy and the demand for credit improving, and increasing the pressure on long-term interest rates, which would have the effect of reducing bond prices and total returns. As economic prospects look to improve, and corporate profit growth to be maintained and even accelerate, stocks will appear to be a better investment than bonds, particularly as interest rates may appear to stabilize, if not rise substantially.
Earlier in this article, inflation was addressed. To expand on that part of the bear thesis, it is still true that a huge increase in the money supply will, normally, ultimately cause large price gains, sometimes only in assets, as occurred with the tech bubble in the late 1990’s, but usually in all goods and services in general price inflation. We are seeing that now.
Inflation is well over 3%, having risen from negative values two years ago. In every month since April, inflation has exceeded 3%, and it has accelerated in every month save June, when it subsided by just 0.01%. It was 3.87% in September, much higher than the under-3.0% yield 30-year Treasurys hit in early October.
In the 1990’s, there were investors, traders, and speculators known as the ‘bond vigilantes,’ who would sell down bonds, and financial futures related to them, whenever there was an uptick in the inflation rate, or signs that such a trend was imminent. This was a great worry to the Clinton administration, and one reason that they were amenable to deficit reduction strategies that culminated in surpluses in the last two years of the last century and one in the first fiscal year of this century. There are few signs of that sort of motivation now.
U.S. federal deficits are projected to be well over one trillion dollars per year for the next several years, absent any major budget action in Washington. That is nearly 7% of Gross Domestic Product.
Currently, the Fed has been monetizing that debt; i.e., funding it by expanding the money supply. Other nations that have attempted to do that have only kept inflation from increasing at a faster and faster pace have only been able to forestall that fate by having a high domestic savings rate, which the United States does not, despite some recent improvement. Real economic growth is around 2% per annum. Thus, the resultant possible inflation is approximately 5%, meaning it has further to go.
The Fed has already stated that its quantitative easing and variant on it, ‘Operation Twist,’ are effectively over. However, it seems unlikely, given the anemic job growth and government revenue situation, to quit it entirely. Should it continue to fund government borrowing as it has, by ‘printing’ money, inflation will increase. The price of gold in recent weeks may be signaling this perception on the part of investors.
Should inflation become substantially higher, on a sustained basis, and well above the current yield to maturity on long Treasuries, more and more investors, and likely all the speculators and traders, will move some money out of Treasuries and linked financial futures, and into inflation-indexed instruments or into other asset classes entirely.
Prices of financial assets are determined at the margin; by the prices that some volume, even a small amount, trade at. It does not have to take a big move by everyone to cause bond prices to fall, and, as mentioned earlier, at current duration values, the losses could be painful. Once such a trend starts, it could also be self-perpetuating, making it worse.
There could also be a flight out of the dollar, as U.S. and foreign investors move out of safe, liquid Treasurys and into foreign currency-denominated assets. While there is no single other major currency that is a clear, strong alternative to the U.S. dollar, since, for the next several quarters, if not years, the Euro may be weak due to low growth, weak public revenues, and low interest rates, there does not have to be a single strong candidate.
Indeed, given the experience investors have had in this new millennium, it makes eminent sense to diversify into as many other reasonably investment grade securities in as wide a dispersal as is practicable. Switzerland, Canada, Australia and Singapore may not be as broad and deep as necessary, but they do not have to be the only safe havens. Places as far afield as India, Brazil, Indonesia, Turkey, Indonesia, and Norway, may be attractive. Within the EU, Germany, Poland, The Netherlands, and Denmark could still be viable as investment locations, despite some currency risk.
The point is that the Unites States is not the only game in town, or the world. When money starts flowing out, its currency will decline, making inflation worse as the prices of imported goods rise. This is also a trend that could feed on itself. This would be what is known as a ‘currency crisis.’ It is very unlikely that the Fed could blunt it much, let alone stop it entirely. Both inflation and interest rates, on the short and long ends, would rise substantially, putting an end to this historic bull market in bonds.
To sum and conclude, there are practical limits, and financial limits to how low long-term interest rates can and will go, and thusly perpetuate the increase in bond prices and total returns. It is unlikely to persist for more than another few quarters, and could well end sooner than that, as inflation and credit demand and supply risks increase, and become apparent to investors, who will then move more and more money to other instruments, and perhaps other currencies and markets.
Even from just a prudent rebalancing perspective alone, investors should seriously consider reallocating assets away from bonds, to some extent, and place money into other asset classes, like U.S. equities, which have underperformed, and have thus become a smaller part of the total pool of global investable assets.
The U.S. economy may remain dismal, but the high public fiscal demands will entail higher inflation or higher interest rates to attract bond investors, either of which will hurt bond prices and put an end to the longest bull market in bonds in history. It may not happen tomorrow, next week, or month, or possibly even next year, but it would be reckless to keep U.S. Treasuries as a dominant investment for much longer.
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