What the Bond Market Turmoil Really Means
By Randall W. Forsyth
I’m not dead!
The bond market these days seems to be acting out a scene from Monty Python and the Holy Grail: During the Great Plague, a collector of corpses making his rounds encounters somebody who protests he hasn’t died yet. Another fellow, who wants his buddy to be removed presently rather than risk being stuck with his remains until the corpse gatherer returns in a few days, counters that “he will be soon; he’s very ill.” Eventually, the problem is solved when the poor guy is whacked over the head and tossed in the cart with the rest of the bodies.
All of which may serve to demonstrate that the Pythons’ brand of humor appeals mainly to males of the baby-boomer generation—and everybody else, not so much. Yet the rise in yields has spurred any number of investors and analysts to declare the death of the bull market in bonds, which began in 1981 when long-term Treasury yields topped 15%. Since then, there has been a steady, stairstep decline to a low of 1.36% on the 10-year Treasury note in mid-2016. (Bond prices and yields move in the opposite direction.)
Last week, as the benchmark yield topped 2.5%, the calls declaring the 36-year bond bull dead grew louder, as the Current Yield column details. Whether the bull has actually met its demise remains debatable. But even if that is the case, whether it means the end of the climb in the stock market and the expansion in the global economy is at hand is another matter altogether.
To be sure, there have been earlier, but premature, declarations that the bond bull market had met its demise, including in Up & Down Wall Street’s online edition back in October 2012, which cited a call by Bank of America Merrill Lynch’s chief strategist Michael Hartnett. Yields—then a bit under 2% for the 10-year Treasury—did have further to fall. But Hartnett also recommended overweighting assets that would benefit from central banks’ liquidity expansion, including U.S. stocks, and especially technology. That advice proved profitable. Over that span, the Standard & Poor’s 500 index nearly doubled in price, while the Nasdaq Composite has done even better, in case you haven’t noticed.
Throughout most investors’ careers, interest rates have been in a broadly declining trend, which provides a tailwind to the prices of most assets, from stocks to high-yield credit to real estate. As DoubleLine’s Jeffrey Gundlach observes in the Barron’s Roundtable, when he got into the investment business, the Treasury long bond yield hit 14%, while inflation was 4% and falling.
This combination appeared in May 1984, providing an unparalleled 10% real return on a U.S. government obligation, a never-to-be-repeated opportunity. Barron’s online files don’t go back that far, but I vividly recall our Robert Bleiberg pounding the editorial table to buy bonds at those yields. The Dow Jones Industrial Average then hovered around 1,100 (no, I didn’t drop a zero), which shows just how much stocks and bonds alike have benefited from the three-decade-plus decline in interest rates.
It would seem we’re now at the polar opposite moment, with 10-year Treasuries, at 2.55%, barely yielding more than inflation. (The consumer-price index is up 2.1% in the past 12 months, according to the latest data out Friday morning.) If the long-term secular trend in interest rates is beginning to reverse, is that fatal to the bull market in equities?
To a couple of pros, whose perspectives extend beyond a market environment in which falling interest rates presented a boost, rather than a barrier, to investment returns, that’s not a worry.
Higher bond yields, along with higher stock prices, would be like “ice cream on top of the cake” for much of Corporate America, says Dan Fuss, the octogenarian vice chairman of Loomis Sayles, who has 59 years of investment experience. That combination would bolster the pension plans for the companies that still provide them.
To illustrate, despite the stock market’s sparkling performance in 2017, pension consultants Milliman found that the top 100 corporate pension plans experienced a $2 billion worsening in their funding status. That’s because their discount rate for future liabilities fell to 3.53% at the end of 2017 from 3.99% a year earlier, raising the present value of those liabilities.
For those who didn’t suffer through Finance 101, think how easy it would be to save for retirement if you could lock in yields of 7% or more without risk. Companies with defined-benefit retirement plans have to assume a return of about half that, based on the yield on investment-grade corporate bonds. That means they have to sock away much more to meet those future obligations, just as folks scrimping have to set aside more in their 401(k)s to provide for their golden years. (This leaves aside the many public pension plans that have much larger deficits, given their unrealistic return assumptions, which is a discussion for another time.)
OVER THE TRULY LONG TERM, there are other factors to consider. Louise Yamada, who heads the technical advisory firm bearing her name, looked at more than two centuries of U.S. interest rates and found several recurring characteristics.
First of all, rate cycles have lasted from 22 to 37 years, so the current one of 36 years is at the lengthier end of the range. Secondly, reversals of trends have tended to be sharp, as when yields fell from double digits in the early 1980s or when they bounced from their extreme lows in 2016. That said, the transitions from declining rate regimes to rising ones have been very slow, shallow affairs “that have taken two to 14 years,” she says.
Investors need to bear in mind the historical pattern. As Fuss of Loomis Sayles has suggested for some time, interest rates are in the “foothills” of a climb. Yamada’s work shows the early years of a climb in rates corresponds to an abatement of deflationary pressures. As long as those depressants on prices remain in place, rates don’t rise enough to hurt.
An analysis of charts can tell what is happening. It doesn’t explain why, however.
With that in mind, Yamada’s work shows Treasury yields have moved above downtrend lines on charts extending back to 1981. In particular, the two-year Treasury note yield topped the 2% mark on Friday for the first time since 2008. The 10-year note also moved up to key levels. It hit 2.6%, short of the 2017 peak of 2.63%, and ended the week at 2.55%.
Yamada calculates that a bond bear market would begin in earnest whenever the 10-year Treasury yield breaches the 3% resistance level that has persisted for six years. That’s far off at this point, but she suggests selling longer-duration fixed-income assets into strength, that is, lower yields, and shifting into shorter assets (more on that later).
For stock investors, the direction of interest rates seems to matter less than the point at which we stand in the cycle. At the extremes, it’s negative. Soaring rates when inflation is high, or plunging rates when deflation takes hold, correspond to structural bear markets, Yamada’s work shows. Reversals from those extremes support new, structural equity bull markets.
In other words, moderation in all things is a good thing. So, if interest rates rise from a historically low level, it’s not necessarily a bad thing.
A modest rise in yields suggests an abatement in downward price pressures. In the event of an extreme jump in rates, Fuss argues, the Federal Reserve will resist a destabilizing surge. All of which would translate to a gradual rise in interest rates, but from historically low levels. That shouldn’t be too painful for the stock market or economy.
For those who want to ride out rising rates, the Fund of Information column points out money-market mutual funds finally paying something visible to the naked eye, over 1% in many cases, as the Fed has raised its target rate to a range of 1.25% to 1.5%.
In an interview with CNBC last week, Berkshire Hathaway CEO Warren Buffett said his firm stashed its cash in Treasury bills and estimated that Berkshire owns about $100 billion in T-bills. Emulating the Oracle of Omaha rarely has been a bad thing, and that goes for savers now.
One-month bills yielded 1.3% Friday, while three-month bills yielded 1.44% and six-month bills returned 1.6%. Hardly anything to send your heart aflutter, but a darned sight better than what most bank accounts, brokerages, or money funds yield.
It goes without saying that T-bills are the gold standard in terms of safety and liquidity for institutional investors such as Berkshire. And for individual investors in high-tax states, the elimination of the deduction for state and local taxes under the new tax law makes Treasuries’ exemption from state and local income levies all the more attractive.
Buying government securities at auctions via its website, treasurydirect.gov, is relatively simple.
Many major online brokers, including Fidelity, Charles Schwab, E*Trade, and Vanguard, charge no fee to purchase or sell Treasury securities.
What could be more contrarian in a market melt-up than cash?
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