Voices: Why a Treasurys bear market may not live up to the hype
U.S. Treasuries provide the closest thing on the planet to the risk-free rate of return, a crucial element in financial theory used to value a wide swath of global assets. After all, they make up the largest and most liquid bond market, the dollar is the reserve currency of the world, and top ratings from most major credit agencies signal virtually no risk of a default.
Lately, though, the trend among many Wall Street practitioners is to outdo one another with grandiose statements about how much risk is actually embedded within the $14.9 trillion Treasury market. By their logic, after years of rock-bottom interest rates as the global economy recovered from the post-crisis recession, rates are destined to head higher — and in a hurry. The most common shorthand for this doomsday scenario: the bond bear market.
At first glance, it’s an easy call. The bull run has lasted three decades, pushing yields on 10-year U.S. Treasury notes from as high as 15.8% in 1981 to 1.32% in 2016. Across the Atlantic, yields have turned negative in Germany, France and Switzerland. Same in Japan. Paying governments, in effect, for the privilege of owning their debt? Surely that’s not sustainable.
In the U.S., at least, bond bears have been vindicated — sort of. The 10-year Treasury yield rose above 3% in April for the first time in more than four years. The consensus is that the rate will end 2018 even higher, as the U.S.’s increasing budget deficits force larger and larger monthly debt auctions by the federal government.
Yet investors in Treasurys have lost only 2% this year. By contrast, the S&P 500 index of stocks lost that much in one day on seven occasions during the first four months of 2018. If you listened to prognosticators, you’d have no idea which asset class was the risky one.
Ray Dalio of Bridgewater Associates LP, the world’s largest hedge fund, said earlier this year that he sees Treasury yields rising to such an extent that we’ll have “the largest bear market in bonds that we have seen since 1980 to 1981.” Dalio’s proclamation came just after market guru Bill Gross tweeted, “Bond bear market confirmed today,” a few days into the new year. In early May, mere weeks after Treasurys hit their 3% milestone, JPMorgan Chase CEO Jamie Dimon said he could envision a 4% yield.
It’s too soon to say if this trio of billionaires and like-minded bond watchers will be proven correct. After all, much like gold bugs, bond traders tend to be a pessimistic bunch. But there’s something different about the negativity this time around. Usually the gloomy outlook extends to U.S. economic growth and the pace of inflation — not the fate of the Treasury market.
Gross, of course, became associated with the idea of a “new normal” while at Pacific Investment Management Co., the company he co-founded. Just after the financial crisis, he felt that investors would need to brace themselves for a permanently weaker-than-usual economy and subdued returns on risk assets. In his thinking, the country’s debt load was becoming unsustainable, and the U.S. would struggle to return to the days of low unemployment and subdued inflation.
As we know now, that’s not how it panned out. The national debt has ballooned to more than $21 trillion, roughly double what it was at the end of 2009, with few repercussions. Americans found work again, pushing the unemployment rate below 4% for the first time since 2000. The problem with inflation is that it’s too low, not too high, many economists say, no matter what the Federal Reserve does.
And yet those same specters still keep fixed-income investors up at night. With the Trump administration having ushered in sweeping tax cuts, America’s budget deficit is poised to exceed $1 trillion by 2020. The Treasury Department is asking top Wall Street banks how much it can realistically borrow without rattling the market. Will the biggest buyers of U.S. debt (China and Japan) continue to open their wallets? In addition to all those questions, inflation expectations have roared back to their highest levels since 2014.
Treasury Secretary Steven Mnuchin, for his part, isn’t losing sleep over all this. “By definition, supply and demand will equate,” he said on April 30. “I’m not concerned about that. I think that there are still a lot of buyers for U.S. Treasurys.” The retort to that, naturally, is this adage: “There is no such thing as a bad bond, just a bad price.” In other words, higher yields will be necessary to clear the market.
Bond bulls aren’t so sure. In their minds, this whole cycle of increased debt and higher interest expense for the federal government only bolsters their case that in the long run, yields will be lower as the Fed again cuts its lending rate and steps in to buy bonds. It has to; otherwise borrowing will be unsustainable. All the while, the debt overhang will constrict growth and keep inflation in check.
In other words, just as the 6% 10-year yields of the early 2000s look unfathomable now, so too will today’s 3% one day. “Important to the long-term investor is the pernicious impact of exploding debt levels,” Van Hoisington and Lacy Hunt wrote earlier this year. They oversee the Wasatch-Hoisington U.S. Treasury Fund, which invests almost all its money in long-term government bonds. “No matter how U.S., Japanese, Chinese, European or emerging-market debt is financed or owned, and regardless of the economic system, the path is stagnation and then decline,” they wrote. “High-quality yields may be difficult to obtain within the next decade.” In the near term, they said, “restrictive monetary policy will bring about lower long-term interest rates.”
When it comes to bonds, the value of the investment really all boils down to the fixed interest an investor can get over the life of the security. If you’re of the same mind as Hoisington and Hunt, locking in 3% for 10 years isn’t a bad proposition when economic growth looks unlikely to reach that level consistently in the coming decade.
Even if you don’t share their dim outlook, it’s hard to ignore what higher Treasury yields do to investment propositions across asset classes. The simplest gauge is the dividend yield on the S&P 500 index. Since the start of the financial crisis, it persistently exceeded the yield on two-year Treasury notes.
That is, until 2018.
Now investors can buy even a six-month Treasury bill with an annualized yield that’s better than that of the S&P 500. Suddenly, purchasing stocks for income doesn’t quite make sense. High-dividend company shares are feeling that pinch.
It’s an open question how much longer these types of yields can last. For all the concern about a bond bear market, there’s growing angst that America’s second-longest economic expansion on record doesn’t have much more room to run. Should the U.S. fall into a recession, interest rates would fall as the Fed loosens policy.
Central bankers aren’t worried just yet about a weakening economy. But they’ve begun to note the flattening U.S. yield curve. The gap between yields on short- and long-term Treasury maturities is almost the smallest it’s been in more than a decade. It’s turned negative — meaning the curve inverts — before each of the past seven recessions. Some strategists think that will happen sometime before year-end.
That distortion usually doesn’t last too long. In most scenarios, a higher return to lock money away for two years rather than 10 makes little sense. “You have a lot of mixed signals out there,” says Brian Edmonds, head of interest rates trading at Cantor Fitzgerald LP, a primary dealer, which is to say one of the Fed’s preferred bond-trading partners. “There is a feeling at times, when the market really looks at what the Fed is doing, it looks like they want to raise rates when they can so they can lower rates if needed.”
That’s not exactly a ringing endorsement of the economy, the outlook for inflation, or, by extension, higher Treasury yields. It’s particularly unsettling if you think the expansion will falter under the weight of higher borrowing costs for companies, municipalities and individuals. If anything, as the Fed continues on its self-described path of “gradual tightening,” investors should start adding more Treasurys, which outperform in bad times. Evidence is mounting that private pensions, which oversee more than $3 trillion of assets, are doing just that in an effort to reduce risk in their portfolios.
Even as the losses mount with interest rates marching higher, they are nothing compared with the prolonged bear market in the late 1970s and early ’80s, when core inflation peaked at 13.6% in June 1980. Even the most ardent inflationistas don’t expect it to get back to that level, given the rapid technological advancement that’s quickly reducing the cost for everything from computing power to shipping logistics.
Against that backdrop, it’s tough to paint a truly harrowing picture for Treasurys. Gross, even though he made the call, has tried to distance himself from it, explaining that investors should expect only modest losses. “It’s a hibernating bear market,” he said in a May 2 interview on Bloomberg Television. “The bear is awake, but not really growling.”
And that could be the real takeaway. It’s a mundane call, and it certainly lacks the sexiness of a bond bubble about to burst. But with Treasurys, we’re talking about a purportedly risk-free asset. Maybe a little bit of pain is enough for investors after decades of profits. Just because the good times are over doesn’t mean the end is nigh.