“The Bond Rally of a Lifetime”
John Mauldin
In 1981, as inflation and Treasury yields were screaming to new heights, good friend Gary Shilling had the audacity to announce, “We’re entering the bond rally of a lifetime.” He was right, as that bond rally is already 35 years old and I think it will see a few more birthdays. Gary’s with us today to assert that the rally is still underway – and to back up that assertion with a rather compelling case for Treasuries and for the “long bond” (the 30-year) in particular.
Gary recalls his famous public debate on stocks versus bonds with Professor Jeremy Siegel of Wharton, in 2006 – just before the Great Recession kicked in and sent Treasury prices sky-high. Siegel remarked to the audience of 500, “I don’t know why anyone in their right mind would tie up their money for 30 years for a 4.75% yield” (the then-yield on the 30-year Treasury). When it was Gary’s turn, he asked the audience, “What’s the maturity on stocks?”
He got no answer, but pointed out that unless a company merges or goes bankrupt, the maturity on its stock is infinity – it has no maturity. His follow-up question was, “What is the yield on stocks?” to which someone correctly replied, “It’s 2% on the S&P 500.”
He got no answer, but pointed out that unless a company merges or goes bankrupt, the maturity on its stock is infinity – it has no maturity. His follow-up question was, “What is the yield on stocks?” to which someone correctly replied, “It’s 2% on the S&P 500.”
Gary continued, “I don’t know why anyone would tie up money for infinity for a 2% yield. I’ve never, never, never bought Treasury bonds for yield, but for appreciation, the same reason that most people buy stocks. I couldn't care less what the yield is, as long as it’s going down since, then, Treasury prices are rising.”
Gary admits that “It's a lot more interesting at a cocktail party to talk about the unlimited potential of a new online retailer that sells dog food to Alaskan dogsledders than to discuss the different trading characteristics of a Treasury of 20- compared to 30-year maturity”; but in today’s OTB he gives us a whole list of excellent reasons to give Treasuries the respect they so richly deserve.
Be sure to note Gary’s special offer of his monthly INSIGHT, at the conclusion of the article.
I write to you from 32,000 feet, flying to Missoula, Montana, on my way to Flathead Lake and my friend Darrell Cain. Part research trip, part business meeting, some wonderful writing time, and of course a little vacation. You do have to take some time off when you get to special places. And Shane is with me and will force me to relax a bit and enjoy life.
I am really looking forward to visiting with the five young rocket scientists Darrell has assembled to talk about the future of space. (Is it just me, or do you experience the same mental thought insertion when you say the words future of space and then want to add the final frontier?) And what better place to talk about that than while gazing into the truly clear night sky, lit by so many hundreds of thousands of stars at Flathead Lake, and during what is expected to be the best Perseid meteor shower of the past 20 years? When I was there a few years ago we would sit out every night around a small campfire and watch the space station go by right over our heads as it whizzed around the globe.
I am simply overwhelmed by my immersion into this book-writing process. No other project in my life has so deeply afffected my thinking. Every other book I’ve written, I knew roughly where I was going. Thinking about the changes coming in the next 20 years and in over 30 different areas of life, all of which affect the others, is forcing me to rethink a great many propositions that I have held to be true and right. I knew the future of work would be the hardest chapter, but I didn’t expect it to be so emotion-charged.
Confession: Longtime readers know that I have glibly used the phrase, “I don’t know where the future jobs will come from, but they will.” Because that has been the case in the past. But when you begin to closely examine the data, you see reasons why that positive outcome for jobs may not repeat in our future. Now, maybe something will come along to change the jobs trajectory, and I am really looking for it. Trust me, I prefer the optimistic viewpoint. But rather than settling for a techno-optimist gratuitous happy ending, I much prefer to write what I think is realistic, whether it turns out to be right or wrong.
Ironically, the technology part of the book (roughly the first half) is going to be more optimistic with regard to the future than I believed it would be when I started this project a few years ago. Twenty years from now, none of us are going to want to go back to the good old days of 2016. But the societal upheaval that may come with the collapse of the biggest bubble in human history – that of government promises – is suggesting a tumultuous ending that will make Mr. Toad’s Wild Ride seem quite tame. I much prefer movies with happy endings where the good guy wins, but right now I am at the part of the movie where the good guy is in deep kimchi. I guess we have to wait and see how the writer finishes the movie.
Except that I’m the writer of this particular script, and I’m not at all comfortable with the direction our middle-class hero is heading. I can see a whole host of silver linings, but I can’t get rid of that damn dark cloud, at least so far. It’s probably because I haven’t gotten deep enough into the woods to begin to see out the other side and find the way through to rainbows and puppies. At least that’s what I’m telling myself. If I really thought there was no way the movie could end happily, I might just get up and walk out before I really got into it.
But I see an immediate happy ending in my life. When I get off the plane and go to Flathead Lake, Darrell will have ordered a cherry pie made by a local bakery staffed by Mennonite women. It turns out that Flathead Lake is in the middle of cherry tree world, and these pies are made with the freshest of cherries and a pie crust that is so light it practically flies off the plate. Yes, they have other pies, which are all out of this world, but cherry is my favorite and this is the greatest cherry pie in the history of the world. Not that I might be given to a little storytelling embellishment, you understand. But in my personal experience, that pie, enjoyed with a little homemade vanilla ice cream, while looking up at the night stars and the space station, not to mention 100 meteorites an hour, is about as good as it gets.
You have a great week. I certainly intend to, and I fully expect that you will see a letter for me this weekend. And now let’s think about deflation and the virtues of Treasuries.
Your living in the future analyst,
John Mauldin, Editor
Outside the Box
“The Bond Rally of a
Lifetime”
By A. Gary Shilling
(excerpted from the August 2016 edition of A. Gary Shilling's INSIGHT)
(excerpted from the August 2016 edition of A. Gary Shilling's INSIGHT)
We’ve been bulls on 30-year Treasury bonds since
1981 when we stated, “We’re entering the bond rally of a lifetime.” It’s still
under way, in our opinion. Their yields back then were 15.2%, but our forecast
called for huge declines in inflation and, with it, a gigantic fall in bond
yields to our then-target of 3%.
The Cause of Inflation
We’ve argued that the root of inflation is excess
demand, and historically it’s caused by huge government spending on top of a
fully-employed economy. That happens during wars, and so inflation and
wars always go together, going back to the French and Indian War, the
Revolutionary War, the War of 1812, the Mexican War of 1846, the Civil War, the
Spanish American War of 1898, World Wars I and II and the Korean War. In
the late 1960s and 1970s, huge government spending, and the associated
double-digit inflation (Chart 1), resulted from the Vietnam War on
top's LBJ’s War on Poverty.
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_1_20160810_OTB.jpg)
By the late 1970s, however, the frustrations over
military stalemate and loss of American lives in Vietnam as well as the
failures of the War on Poverty and Great Society programs to propel
lower-income folks led to a rejection of voters’ belief that government could
aid Americans and solve major problems. The first clear manifestation of
this switch in conviction was Proposition 13 in California, which limited
residential real estate taxes. That was followed by the 1980 election of
Ronald Reagan, who declared that government was the basic problem, not
the solution to the nation’s woes.
This belief convinced us that Washington’s
involvement in the economy would atrophy and so would inflation. Given
the close correlation between inflation and Treasury bond yields (Chart 1), we
then forecast the unwinding of inflation—disinflation—and a related
breathtaking decline in Treasury bond yields to 3%, as noted earlier. At
that time, virtually no one believed our forecast since most thought that
double-digit inflation would last indefinitely.
Lock Up For Infinity?
Despite the high initial yields on “the long bond,”
as the most-recently issued 30-year Treasury is called, our focus has always
been on price appreciation as yields drop, not on yields, per se.
A vivid
example of this strategy occurred in March 2006—before the 2007–2009 Great
Recession promoted the nosedive in stocks and leap in Treasury bond prices. I
was invited by Professor Jeremy Siegel of Wharton for a public debate on stocks
versus bonds. He, of course, favored stocks and I advocated Treasury bonds.
At one point, he addressed the audience of about
500 and said, “I don’t know why anyone in their right mind would tie up their
money for 30 years for a 4.75% yield [the then-yield on the 30-year Treasury].”
When it came my turn to reply, I asked the audience, “What’s the maturity on
stocks?” I got no answer, but pointed out that unless a company merges or goes
bankrupt, the maturity on its stock is infinity—it has no maturity. My
follow-up question was, “What is the yield on stocks?” to which someone
correctly replied, “It’s 2% on the S&P 500 Index.”
So I continued, “I don’t know why anyone would tie
up money for infinity for a 2% yield.” I was putting the query, apples to
apples, in the same framework as Professor Siegel’s rhetorical question. “I've
never, never, never bought Treasury bonds for yield, but for appreciation, the
same reason that most people buy stocks. I couldn't care less what the
yield is, as long as it's going down since, then, Treasury prices are rising.”
Of course, Siegel isn’t the only one who hates
bonds in general and Treasuries in particular. And because of that, Treasurys,
unlike stocks, are seldom the subject of irrational exuberance. Their leap in
price in the dark days in late 2008 (Chart 2) is a rare exception to a
market that seldom gets giddy, despite the declining trend in yields and
related decline in prices for almost three decades.
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_2_20160810_OTB.jpg)
Treasury Haters
Stockholders inherently hate Treasurys. They say
they don’t understand them. But their quality is unquestioned, and Treasurys
and the forces that move yields are well-defined—Fed policy and inflation or
deflation (Chart 1) are among the few important factors. Stock prices, by
contrast, depend on the business cycle, conditions in that particular industry,
Congressional legislation, the quality of company management, merger and
acquisition possibilities, corporate accounting, company pricing power, new and
old product potentials, and myriad other variables.
Also, many others may see bonds—except for junk,
which really are equities in disguise—as uniform and gray. It's a lot
more interesting at a cocktail party to talk about the unlimited potential of a
new online retailer that sells dog food to Alaskan dogsledders than to discuss
the different trading characteristics of a Treasury of 20- compared to 30-year
maturity. In addition, many brokers have traditionally refrained from
recommending or even discussing bonds with clients. Commissions are much
lower and turnover tends to be much slower than with stocks.
Stockholders also understand that Treasurys
normally rally in weak economic conditions, which are negative for stock
prices, so declining Treasury yields are a bad omen. It was only individual
investors’ extreme distaste for stocks in 2009 after their bloodbath collapse
that precipitated the rush into bond mutual funds that year. They plowed $69
billion into long-term municipal bond funds alone in 2009, up from only $8
billion in 2008 and $11 billion in 2007.
Another reason is that most of those promoting
stocks prefer them to bonds is because they compare equities with short
duration fixed-income securities that did not have long enough maturities to
appreciate much as interest rates declined since the early 1980s.
Investment strategists cite numbers like a 6.7%
annual return for Treasury bond mutual funds for the decade of the 1990s while
the S&P 500 total annual return, including dividends, was 18.1%. But those
government bond funds have average maturities and durations far shorter than on
30-year coupon and zero-coupon Treasurys that we favor and which have way, way
outperformed equities since the early 1980s.
Media Bias
The media also hates Treasury bonds, as their
extremely biased statements reveal. The June 10 edition of The Wall
Street Journal stated: “The frenzy of buying has sparked warnings about
the potential of large losses if interest rates rise. The longer the maturity,
the more sharply a bond’s price falls in response to a rise in rates. And with
yields so low, buyers aren’t getting much income to compensate for that
risk.” Since then, the 30-year Treasury yield has dropped from 2.48% to
2.21% as the price has risen by 8.3%.
Then, the July 1 Journal wrote: “Analysts
have warned that piling into government debt, especially long-term securities
at these slim yields, leaves bondholders vulnerable to the potential of large
capital losses if yields march higher.” Since then, the price of the
30-year Treasury has climbed 1.7%.
While soft-pedaling the tremendous appreciation in
long-term sovereigns this year, Wall Street Journal columnist James
MacKintosh worries about the reverse. On July 28, he wrote, “Investors
are taking a very big risk with these long-dated assets....Japan's 40-year bond
would fall 15% in price if the yield rose by just half a percentage point,
taking it back to where it stood in March. If yields merely rise back to
where they started the year, it would be catastrophic for those who have chased
longer duration. The 30-year Treasury would lose 14% of its value, while
Japan's 40-year would lose a quarter of its value.”
The July 11 edition of the Journal said,
“Changes in monetary policy could also trigger potential losses across the
sovereign bond world. Even a small increase in interest rates could
inflict hefty losses on investors.”
But in response to Brexit, the Bank of England has
already eased, not tightened, credit, with more likely to follow. The
European Central Bank is also likely to pump out more money as is the Bank of
Japan as part of a new $268 billion stimulus package. Meanwhile, even
though Fed Chairwoman Yellen has talked about raising interest rates later this
year, we continue to believe that the next Fed move will be to reduce them.
Major central banks have already driven their
reference rates to essentially zero and now negative in Japan and Europe (Chart
3) while quantitative easing exploded their assets (Chart 4).
The Bank of England immediately after Brexit moved to increase the funds
available for lending by U.K. banks by $200 billion. Earlier, on June 30,
BOE chief Mark Carney said that the central bank would need to cut rates “over
the summer” and hinted at a revival of QE that the BOE ended in July 2012.
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_3_20160810_OTB.jpg)
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_4_20160810_OTB.jpg)
Lonely Bulls
We’ve been pretty lonely as Treasury bond bulls for
35 years, but we’re comfortable being in the minority and tend to make more
money in that position than by running with the herd.
Incidentally, we continue
to favor the 30-year bond over the 10-year note, which became the benchmark
after the Treasury in 2001 stopped issuing the “long bond.” At that time,
the Treasury was retiring debt because of the short-lived federal government
surpluses caused by the post–Cold War decline in defense spending and big
capital gains and other tax collections associated with the Internet stock
bubble.
But after the federal budget returned to deficits
as usual, the Treasury resumed long bond issues in 2006. In addition, after
stock losses in the 2000–2002 bear market, many pension funds wanted
longer-maturity Treasurys to match against the pension benefit liability that
stretched further into the future as people live longer, and they still do.
Maturity Matters
We also prefer the long bond because maturity
matters to appreciation when rates decline.
Because of compound interest, a
30-year bond increases in value much more for each percentage point decline in
interest rates than does a shorter maturity bond (Chart 5).
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_5a_20160810_OTB.jpg)
Note (Chart 6) that at recent interest
rates, a one percentage point fall in rates increases the price of a 5-year
Treasury note by about 4.8%, a 10-year note by around 9.5%, but a 30-year bond
by around 24.2%. Unfortunately, this works both ways, so if interest rates go
up, you’ll lose much more on the bond than the notes if rates rise the same for
both.
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_6_20160810_OTB.jpg)
If you really believe, as we have for 35 years,
that interest rates are going down, you want to own the longest-maturity bond
possible. This is true even if short-term rates were to fall twice as much as
30-year bond yields. Many investors don’t understand this and want only to buy
a longer-maturity bond if its yield is higher.
Others only buy fixed-income securities that mature
when they need the money back. Or they'll buy a ladder of bonds that mature in
a series of future dates. This strikes us as odd, especially for Treasurys that
trade hundreds of billions of dollars’ worth each day and can be easily bought
and sold without disturbing the market price. Of course, when you need the
cash, interest rates may have risen and you’ll sell at a loss, whereas if you
hold a bond until it matures, you’ll get the full par value unless it defaults
in the meanwhile. But what about stocks? They have no maturity so you’re never
sure you’ll get back what you pay for them.
Three Sterling Qualities
We’ve also always liked Treasury coupon and
zero-coupon bonds because of their three sterling qualities. First, they have
gigantic liquidity with hundreds of billions of dollars’ worth trading each
day, as noted earlier. So all but the few largest investors can buy or sell
without disturbing the market.
Second, in most cases, they can’t be called before
maturity. This is an annoying feature of corporate and municipal bonds.
When interest rates are declining and you’d like longer maturities to get more
appreciation per given fall in yields, issuers can call the bonds at fixed
prices, limiting your appreciation. Even if they aren’t called, callable bonds
don’t often rise over the call price because of that threat. But when rates
rise and you prefer shorter maturities, you’re stuck with the bonds until
maturity because issuers have no interest in calling them. It’s a game of heads
the issuer wins, tails the investor loses.
Third, Treasurys are generally considered the
best-quality issues in the world. This was clear in 2008 when 30-year Treasurys
returned 42%, but global corporate bonds fell 8%, emerging market bonds lost
10%, junk bonds dropped 27%, and even investment-grade municipal bonds fell 4%
in price.
Slowing global economic growth and the growing
prospects of deflation are favorable for lower Treasury yields. So is the
likelihood of further ease by central banks, including even a rate cut by the
Fed, as noted earlier.
Along with the dollar (Chart 7), Treasurys
are at the top of the list of investment safe havens as domestic and foreign
investors, who own about half of outstanding Treasurys, clamor for them.
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_7_20160810_OTB.jpg)
Sovereign Shortages
Furthermore, the recent drop in the federal deficit
has reduced government funding needs so the Treasury has reduced the issuance
of bonds in recent years. In addition, tighter regulators force U.S.
financial institutions to hold more Treasurys.
Also, central bank QE has vacuumed up highly-rated
sovereigns, creating shortages among private institutional and individual
buyers. The Fed stopped buying securities in late 2014, but the European
Central Bank and the Bank of Japan, which already owns 34% of outstanding
Japanese government securities, are plunging ahead. The resulting
shortages of sovereigns abroad and the declining interest rates drive foreign
investors to U.S. Treasurys.
Also, as we’ve pointed out repeatedly over the past
two years, low as Treasury yields are, they’re higher than almost all other
developed country sovereigns, some of which are negative (Chart 8).
So an overseas investor can get a better return in Treasurys than his own
sovereigns. And if the dollar continues to rise against his home country
currency, he gets a currency translation gain to boot.
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_8_20160810_OTB.jpg)
"The Bond Rally of a Lifetime"
We believe, then, that what we dubbed “the bond
rally of a lifetime” 35 years ago in 1981 when 30-year Treasurys yielded 15.2%
is still intact. This rally has been tremendous, as shown in Chart 9,
and we happily participated in it as forecasters, money managers and personal
investors.
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_9_20160810_OTB.jpg)
Chart 9 uses 25-year zero-coupon bonds because of
data availability but the returns on 30-year zeros were even greater.
Even still, $100 invested in that 25-year zero-coupon Treasury in October 1981
at the height in yield and low in price and rolled over each year maintains its
maturity or duration to avoid the declining interest rate sensitivity of a bond
as its maturity shortens with the passing years. It was worth $31,688 in
June of this year, for an 18.1% annual gain. In contrast, $100 invested
in the S&P 500 index at its low in July 1982 is now worth $4,620 with
reinvested dividends. So the Treasurys have outperformed stocks by 7.0 times
since the early 1980s.
So far this year, 30-year zero-coupon Treasurys
have returned 26% compared to 3.8% for the S&P 500. And we believe
there’s more to go. Over a year ago, we forecast a 2.0% yield for the
30-year bond and 1.0% for the 10-year note. If yields fall to those
levels by the end of the year from the current 2.21% and 1.5%, respectively,
the total return on the 30-year coupon bond will be 5.7% and 5.6% on the
10-year note. The returns on zero-coupon Treasurys with the same rate
declines will be 6.4% and 5.1% (Chart 10).
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_10_20160810_OTB.jpg)
Besides Treasurys, sovereign bonds of other major
countries have been rallying this year as yields fell (Chart 11) and
investors have stampeded into safe corrals after Brexit.
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_11_20160810_OTB.jpg)
Finally Facing Reality
Interestingly, some in the media are finally facing
the reality of this superior performance of Treasury bonds and backpedaling on
their 35-year assertions that it can’t last. The July 12 Wall Street
Journal stated: “Bonds are churning out returns many equity investors
would envy. Remarkably, more than 80% of returns on U.S., German, Japanese and
U.K. bonds are attributable to gains in price, Barclays index data show.
Bondholders are no longer patient coupon-clippers accruing steady income.”
The July 14 Journal said, “Ultra low
interest rates are here to stay,” and credited not only central bank buying of
sovereigns but also slow global growth. Another Journal article
from that same day noted that central banks can make interest rates even more
negative and, if so, “even bonds bought at today’s low rates could go up in
price.” And in the July 16 Journal, columnist Jason Zweig wrote,
“The generation-long bull market in bonds is probably drawing to a close.
But high quality bonds are still the safest way to counteract the risk of
holding stocks, as this year’s returns for both assets has shown. Even at
today’s emaciated yields, bonds still are worth owning.” What a diametric
change from earlier pessimism on bonds!
The July 11 Journal said, “Recently, the
extra yield investors demand to hold the 10-year relative to the two-year
Treasury note hit its lowest level since November 2007 (Chart 12). In
the past, investors have taken this narrowing spread as a warning sign that
growth momentum may soon slow because the Fed is about to raise interest
rates—a move that would cause shorter-dated bond yields to rise faster than
longer-dated ones. Now, like much else, it is largely being blamed on investors’
quest for yield.” Note (Chart 12) that when the spread went negative,
with 2-year yields exceeding those on 10-year Treasury notes, a recession
always followed. But that was because the Fed's attempts to cool off what
it saw as an overheating economy with higher rates was overdone, precipitating
a business downturn. That's not li kely in today's continuing weak global
economy.
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_12_20160810_OTB.jpg)
Persistent Stock Bulls
Nevertheless, many stock bulls haven’t given up
their persistent love of equities compared to Treasurys. Their new
argument is that Treasury bonds may be providing superior appreciation, but
stocks should be owned for dividend yield.
That, of course, is the exact opposite of the
historical view, but in line with recent results. The 2.1% dividend yield
on the S&P 500 exceeds the 1.50% yield on the 10-year Treasury note and is
close to the 2.21% yield on the 30-year bond. Recently, the stocks that
have performed the best have included those with above average dividend yields
such as telecom, utilities and consumer staples (Chart 13).
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_13_20160810_OTB.jpg)
Then there is the contention by stock bulls that
low interest rates make stocks cheap even through the S&P 500
price-to-earnings ratio, averaged over the last 10 years to iron out cyclical
fluctuations, now is 26 compared to the long-term average of 16.7(Chart 14).
This makes stocks 36% overvalued, assuming that the long run P/E average is
still valid. And note that since the P/E has run above the long-term
average for over a decade, it will fall below it for a number of future
years—if the statistical mean is still relevant.
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_14_20160810_OTB.jpg)
Instead, stock bulls points to the high earnings
yield, the inverse of the P/E, in relation to the 10-year Treasury note
yield. They believe that low interest rates make stocks cheap.
Maybe so, and we’re not at all sure what low and negative nominal interest
rates are telling us.
We’ll know for sure in a year or two. It may
turn out to be the result of aggressive central banks and investors hungry for
yield with few alternatives. Or low rates may foretell global economic
weakness, chronic deflation and even more aggressive central bank largess in
response. We’re guessing the latter is the more likely explanation.
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