It's Time for a Fresh Look at Bonds

The first quarter of 2022 will go down as the worst quarter for the overall bond market in more than four decades. Not only did Treasury rates rise substantially, but municipal and corporate bond spreads also rose, resulting in especially poor performance across all types of bonds. I've been very cautious on rates for over a year, but now may be a good time to revisit that stance. The recent inversion of the yield curve tells us that the Federal Reserve won't be hiking forever. Moreover the risk of a recession is rising, which would provide an obvious catalyst for interest rates to fall. Here is how I'm thinking about my current rates position and when it might be time to change. Yields No Longer 'Low' Depending on how you look at it, bond yields aren't low anymore. The chart below shows the current yield of different bond types vs. the average yield from 2010 until now. Source: Bloomberg Of course, we can debate what the right time period for historic comparison should be. If we used 1990 to today instead, the 10-year Treasury average yield was 4.27%. One could argue that bond yields should be fundamentally higher than the 2010-2020 period, perhaps due to a structural shift in inflation. Regardless, what the chart above shows is that to argue that interest rates will persist much higher than they are now, one has to also argue that something about the economy is fundamentally different than the prior expansion. In other words, the argument isn't as simple as just rates are too darn low. Curve Inversions Often Signal a Top for Longer Yields Last week I wrote about how curve inversions are a sign that the Fed is likely to be cutting its target rate sometime in the near future. This is why an inverted curve has so often been a reliable recession indicator, since the Fed tends to cut rates when the economy is slowing. Hence, it is no surprise that curve inversions also tend to coincide with tops in longer-term yields. If the market has correctly anticipated when the Fed will start cutting rates, that implies that the market has also anticipated where fed funds will peak. Once peak fed funds has been properly priced in, there is impetus for longer-term Treasury yields to keep rising. This has played out in reality more often than not. I took the period from 1990 to now, found all the days where the 2 year-10 year curve first became inverted. Looking 6 months later, I see the 10-year Treasury yield was lower 75% of the time. It may very well be that today's market has not properly anticipated where Fed funds will peak. Remember that just a few weeks ago markets thought the Fed would stop hiking around 2%, and now that is all the way up to nearly 3%. If inflation proves ever more difficult to quell, the Fed will be forced to tighten even more than is currently priced into the curve. I think there is a good argument that such an outcome will matter much more for short-term bonds than long-term bonds, but more on that in a moment. Inflation Expectations Vs. Real Yields There is some debate about whether we should be paying attention to an inversion in nominal or real yields. Nominal is the yield as stated, whereas real yields are what is left over after adjusting for future inflation expectations. We can observe the real yield by looking at the stated yield on a TIPS (Treasury Inflation-Protected Security). Using the TIPS curve, there is no inversion at all. TIPS in 2-years yield -2.13% and the 10-year is -0.52%. How do we reconcile that nominal yields are inverted while real yields aren't? Basically it is saying that as the Fed tightens policy, inflation expectations will fall at a faster rate than real yields will rise. Or put another way, as the Fed hikes, that will cause real yields to rise. At the same time, tightening policy will work in the sense that inflation subsides. Specifically, using TIPS break-evens, markets are anticipating that the consumer price index slows from 7.9% currently to 4.7% over the next two years, and then average 2.5% in the subsequent eight years. Last week I wrote in more detail about curve inversions and what it does and does not tell us. The short version is that an inverted curve suggests the economy will slow enough to elicit Fed rate cuts at some point in the future. In today's case, this is manifesting itself as inflation slowing rapidly over the next two years. It is very likely that such a thing would be accomplished via slowing the economy by some degree. Longer-Term Bond Yields Already Peaked? I have been consistently very cautious on the bond market since August of 2020 when the Fed changed to the Average Inflation Targeting regime. For that whole time, my main thesis wasn't based on some specific forecast of higher inflation, rather it was my view that risks were skewed. The market was poorly priced for higher inflation or a more aggressive Fed or both. This allowed for a very favorable risk/reward potential to positioning for higher yields. Has the spike in yields so far in 2022 changed that? I still think there is limited room for yields to fall from here, especially shorter-term yields. The Fed is going to tighten very aggressively in 2022 almost no matter what, and while that is happening, it will be hard for yields lasting 5-years and in to fall very much. Meanwhile, there is still room for them to move even higher should inflation prove more difficult to quell. But note that even in that scenario, the curve probably just becomes all the more inverted. For example, right now markets think the Fed hikes to 3% and inflation subsides thereafter. Let's say that gets revised to 3.5% or 4%. The 2-year and 3-year Treasuries would have to rise by a lot in response. But what about 10-year or 30-year bonds? If markets still think 4% gets the job done and inflation normalizes in a couple years, the short-term spike in Fed policy will have only a minor effect on longer-term bond pricing. Hence, longer-term yields will move a little higher, but not that much. Note that in the early 1980s, the 2-10 curve was at times 200-basis-points inverted. For longer-term yields to persist meaningfully higher than they are today, one of two things must be true: Either the Fed can't control inflation at all or the trend growth rate of the economy must be fundamentally faster than the 2010-2019 period. I don't put much credence in the former. The later is possible, and would suggest the normal Fed target rate persists higher than the recent past. But even if that winds up being the case, markets have no way of suddenly knowing this is true. In other words, the only way to know that the normal policy rate is higher is for the Fed to hike that high and we see the economy continuing to grow. As a result, markets would first price in tighter Fed policy to short-term bonds, and longer-term yields would eventually catch up as growth surprised to the upside. Meanwhile, there is a very clear scenario in which longer-term yields fall: The market starts pricing in recession risk. In fact, recession risk is probably correlated with inflation risk right now. In other words, the tighter the Fed is forced to get to stop inflation, the greater the risk of that tightness causing a recession. Again, this is how we could see an extremely inverted yield curve, where short-term policy yields force front-end rates to stay high while long-term yields fall. New Risk-Reward With general yields rising as much as they have, the opportunity cost of holding cash or very short-term bonds has gone up. Meanwhile, the risk-reward of longer-term bonds is closer to balanced now. I like being long 20-year to 30-year bonds, while remaining short 5-year to 10-year bonds. If you've been sitting in cash to avoid pain in the bond market, it may be time to rotate back in.

It's Time for a Fresh Look at Bonds

The first quarter was one of the worst in decades for bonds, but if you've been sitting in cash to avoid pain in the bond market, it may be time to rotate back in.

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