Why You Should Be Paying Attention To Bond Yields

September 8, 2017

Why You Should Be Paying Attention To Bond Yields

  • It’s extremely important to watch bond yields as they define the health of the economy and financial markets.
  • I was correct last year when I said to short bonds, but now things are changing and shorting bonds is no longer a low risk thing to do.
  • I’ll discuss what to look for to protect your portfolio from what bond yields are saying.

Introduction

Last year, I was a bond bear and wrote about how investors should avoid bonds, especially as the FED was announcing a tightening policy. I was right on with my forecasts as bond yields have almost doubled since June 2016 which lowered bond values.

Figure 1: 10-year U.S. Treasury yield. Source: FRED.

Nevertheless, as investors, we always need to be assessing the situation in the markets and compare the potential returns to the potential risks in order to keep the risk low and the returns as high as possible. The world, especially the financial world, is changing too fast to stick to the same asset allocation for a longer period of time.

Bond Yields Have Been Declining Lately

As you can see in the figure above, bond yields have been declining since November 2016. The 10 Year Treasury was yielding almost 2.6% then, while today the yield is at 2.1%. This means that the market doesn’t believe the FED and its tightening announcements. This is very interesting as yields are supposed to be rising, not declining.

Let’s figure out what’s going on. The FED’s target for inflation is for it to be at 2%, economic growth at 2%, and unemployment at around 5%.

Figure 2: The FED’s economic targets and projections. Source: Federal Reserve.

The main problem is that inflation isn’t reaching 2% despite the huge monetary stimulus in the last 10 years and the still extremely low interest rates.

Figure 3: Inflation in the last 10 years, 2% seems impossible. Source: FRED.

In January, inflation reached 1.94% and many thought that inflation at 2% or higher had finally arrived. But the inflation rate quickly declined to the current 1.64%, and the trend is negative.

This tells us a few things. For one, it tells us that the economy is extremely dependent on low interest rates as the latest minor increases quickly changed the environment from one where inflation is rising to one when inflation is declining. I would dare to say that any kind of environment with higher interest rates would lead the economy straight into a recession and deflation, which isn’t a nice scenario. Therefore, it’s clear why we have a scenario where the FED is increasing interest rates and discussing balance sheet trimming, and the ECB is announcing the end of its asset purchasing program while bond yields are stubbornly declining. Most think that any kind of tightening is an impossible task, and I concur.

All of this leads to the following conclusions:

  • We will see negative interest rates globally when the next recession arrives because current economic fundamentals don’t allow for higher rates.
  • The average interest rate cut by the FED in past recessions was 5.5 percentage points, which is something that would be impossible at this point as a 6% interest rate environment would immediately lead to a recession, or perhaps even a depression.
  • We must acknowledge the fact that higher interest rates are unlikely to be achieved soon.
  • We haven’t seen a recession yet only because of the FED’s tight grip on the economy. As soon as the FED slips, we will enter a difficult deleveraging process or there will be plenty more liquidity at negative interest rates, perhaps even helicopter money.
  • The bet on higher interest rates should be closed. Interest rates have increased 100% in the last year, and positions should be now closed as the likelihood of higher and lower interest rates is practically equal.

Economic Fundamentals

Another thing I want to show you is that economic fundamentals aren’t better than they were in 2007, and the economic growth we are enjoying is just a product of more debt.

Total public debt was at 62% of GDP in 2007, and it’s now at 104%. I think it’s clear to anyone where the economic growth comes from…

Figure 4: Total public debt to GDP has been surging. Source: FRED.

Higher public debt levels mean only one thing, continued low interest rates as governments can’t afford higher interest rates.

Conclusion & What To Do

The first thing to do is not to bet on higher interest rates anymore. It was a good bet in the last 18 months, but times have changed. Higher interest rates and bond yields are possible, but I don’t like the risk reward of that play.

Secondly, and more importantly, start looking for investments that benefit from lower interest rates and economic turmoil. Thus, hedge your portfolio with some gold and gold miners.

Figure 5: Gold prices have been rising in 2017. Source: FRED.

When it comes to stocks, go for quality and fundamentals over promises. Nobody knows what the world will look like in 5 years and buying something now that has no book value, no earnings, and only future prospects, is extremely risky.

Quality stocks can be found at lower valuations and low price to book values. If you look at emerging markets, you expose yourself to positive economic fundamentals, which isn’t the case for developed countries where all the growth is only because of higher debt levels.