This past summer, I put up a (admittedly rather boring) piece on the concerns I had for bond prices. To be clear, the article contained no prescient points about the ten year returning to 2.2% well before year end! I would like to take credit for such a call, but that was not the case. If it were, the article would have called for a more extreme de-risking in bond positioning – perhaps even to a net short extent. Instead, the case was based on a few data relationships that suggested the US we were susceptible to a shock in rates.
Recap of the shock risks:
Those three concerns were:
- Interest rates on 10 year bonds had stretched way below trend in their relationship to (core) inflation – as far off trend as any point going back to 2013.
- Historically, there is a tight relationship between nominal GDP (the growth rate in the economy before backing out inflation) and the level of 10 year interest rates.
- Despite the common narrative that the US was a “high yield” play , US real rates were actually lower than they normally were in relation to the EU & Japan on a real interest rate basis.
(For a more detailed account of each of these factors you can click here to read the full blog post https://adamharter.com/?p=43)
Update to those shock risks:
- After being stretched to nearly -1% (using core inflation to compute), real yields have bounced back up towards 0. However, real yields would still need to move up about another 30bps to reach their 5 year average.
It should be noted that core prices could easily moderate over the next couple of months and do their part to boost real yields without a further move up in outright level of interest rates.
- The jump in rates has only made the first step towards converging to its long term relationship with nominal GDP.
- Global yields have moved up in tandem which does not really change the relative value of US bonds to their EU and Japanese counterparts.
Where does that leave us for positioning?
Longer term – we really do need to be cognizant of the possibility that we are amidst a sea change in market environments. I’m not just talking US politics here and the potential for budget deficits that lead to inflation. Other factors were already stepping out of the batter’s box. Namely, as the US retires 10,000 workers a day – those boomers will be shifting from the accumulation phase of finance to the distribution (whether that is through pension or private savings). These factors, coupled with the underlying relationships above, suggest we may just be through the first 2 or 3 innings of the adjustment process
Shorter term – there hasn’t really been enough time for 2 or 3 innings of the adjustment process and there is plenty of opportunity for things to settle down. In my estimation, way too much certainty has been quickly built into these probable inflationary/higher rate scenarios. If so, that leaves plenty of short term room for probabilities to adjust, allowing bond investors to stabilize their principal while earning their coupons. Just maybe, we even get a Santa Claus rally back up in price for bonds.
As we go forward, a lot will depend on what ultimately happens to nominal GDP. Jeff Gundlach talked in his weekend Barron’s interview about the nominal economy getting back to 4, 5 or even 6%. The difference between the upper and lower of these levels (4 or 6%) would mean significantly different return outcomes for bonds. A lot also depends on the amount of time it would take to get back up there. As of now, in late 2016, I think a key point is that we aren’t going to get there all at once. We can use the short run to collect coupons, perhaps make a tactical trade to the upside, and prepare the portfolio for the forthcoming innings.
