The Long & Short Term Outlook For Bonds Is Scary At Best

January 20, 2017

The Long & Short Term Outlook For Bonds Is Scary At Best

  • As we are still far away from the FED’s target interest rate, bonds have plenty more room to fall.
  • Inflation could force the FED to hike rates and push bonds down very quickly.
  • This is probably the end of the 35-year bond bull market that has beaten the S&P 500 by five times.

Introduction

I haven’t written about bonds since back in July when I said that bonds were extremely risky (article available here).

Unfortunately for bond holders, my call was prescient to the point of perfection because yields went up and consequently bonds prices went down.


Figure 1: 10-year treasury yield constant maturity rate. Source: FRED.

A disclaimer here: I could have easily been wrong about bonds back in July. If I were able to correctly time yield movements, I would trade bonds for a while and then retire as one of the richest traders in the world. Therefore, be very careful when someone tells you where yields are going to go in the short term.

However, what can be done is estimate probabilities for higher or lower yields based on cyclical macro trends that, in aggregate, should lower your long-term risk and increase returns.

As bond yields moved significantly away from their 2016 extremely low yields, it’s time to examine the bond market again in order to give you a short and long term overview of the risks and rewards.

Long Term View Of The Bond Market

Bonds have enjoyed a 35-year bull market. 30-year treasury yields went from above 15% in 1981 to the current 3%. An investment in the long-term bond back in 1981 would have outperformed the S&P 500 five times. Don’t forget that the S&P 500 back then was at 122 points and is currently at 2,269.


Figure 2: 30-year treasury yield constant maturity rate. Source: FRED.

You might be thinking how lucky those who invested in bonds in 1981 were. But they weren’t lucky. The were extremely courageous as at the time they invested in bonds, there seemed to be no end in sight for ramping inflation and bonds had been the worst performers of the previous years. Therefore, the amazing returns were well deserved.

Amazing returns aside, what’s going to determine future returns from bonds is, as always, the yield. The main factors that determine bond yields are a mix of the FED’s interest rate, inflation, and economic growth.

The FED

The FED clearly announced that its intention is to increase interest rates three times in 2017 according to their baseline scenario. Current yields have two hikes priced in, so if the FED is correct in their estimations, 2017 should be a negative year for bonds. Going further, if the FED’s scenario evolves correctly, bonds should enter a strong bear market as the gains from this extremely long bull market reverse.


Figure 3: FED’s projected interest rate increases. Source: FED.

If the FED raises interest rates to 3%, long term bond yields will be close to 6%. The last time this was the case was in the 1990s. This would revert the gains bonds have enjoyed in the last two decades and a 50% contraction shouldn’t be a surprise.


Figure 4: iShares 20+ Year Treasury Bond ETF (TLT). Source: iShares.

Inflation

Similarly to, and correlated with interest rates, is the FED’s expectation for inflation. The FED’s goal for inflation is to reach 2% and then keep it there. As inflation came in at 2.1% in the last measurement, the FED’s goal has been reached.


Figure 5: U.S. inflation rate. Source: Trading Economics.

However, the FED will now have to prevent inflation from going higher by increasing rates, thus negatively impacting bonds. The historical inflation average in the last 100 years is 3.29%, so we shouldn’t be surprised if inflation settles at a higher level than 2%, again, negatively impacting bonds.

In general, inflation is driven by the ratio of money supply and available goods. If there is more money, inflation will be higher and vice versa. In an environment where the developed world population is aging, governments and monetary institutions are doing whatever they can to spur economic growth. This usually involves pumping more money in to the system. Thanks to global improvements in technology, lower production costs, and a general oversupply of goods, pumping money into the system hasn’t increased inflation. However, there is a real danger that inflation might get out of control as money becomes less valuable.

Even Buffett is puzzled by the low inflation. Back in 2015 Buffett said that he: “expected significant inflation by now because of the measures taken to revive the economy after the last recession.”

There is a huge risk that the accommodative global monetary policies will lead to severe global inflation. In such an environment, bonds aren’t the place to be.

Economic Growth

Unfortunately, a recession is the only thing that can save bondholders. That is, the opposite of economic growth as a recession would force the fed to lower rates, lower inflation, and consequently lower yields. If the economy continues to grow, or even overheats, bonds will not do well.

An even more terrifying situation would be stagflation, where the economy enters a recession but due to external shocks inflation persists. This would disable the FED from lowering rates and lead to a depression. As current monetary policies have never been tested, anything is possible.

Short Term Outlook

I wish I could know what will happen with bonds in the short term, but in an environment where the President’s tweets move markets, I say it’s impossible to know what will happen tomorrow or in the next few months. Therefore, a long-term outlook is the best thing to look at.

Conclusion On The Long-Term Outlook

Bonds might rebound as they have fallen pretty badly in the last 6 months. However, the macro developments explained above are still showing extremely high levels of risk.

The 30-year treasury yield is just 100 basis points above inflation. This means that your real return is only 1%. If rates further increase, you could lose 50% of your investment in current values. The asymmetric risk reward continues to be extremely negative.

On the positive, bonds eventually mature, need to be repaid, and you can renegotiate your yield. So, if that is the game you want to play, good, but don’t say you haven’t been warned.