For weeks now, it looks like I have been wrong on my long bonds positions: the 20+ Year Treasury Bond Fund (TLT) and the Vanguard Extended Duration Bond Fund (EDV). And I have been! But that may be changing. Specifically, the turn may have occurred last Thursday when TLT closed up 2% and EDV closed up 3%. It was equally encouraging that they didn’t correct on Friday.
As I write this post both TLT and EDV are up marginally for the week. Meanwhile, the S&P 500 was hit hard on Friday and is down marginally on the week thus far. Obviously, 3 days does not make a new trend. But I continue to firmly believe that interest rates will be lower at the end of the year than they are now. And I still believe that TLT and EDV represent more opportunity for growth than stocks.
Let me summarize the countless hours of research and thought that have led me to this conclusion… and the research continues each day and (to be fair) my viewpoint may change as the data does.
The three key issues affecting bond interest rates are the economy, the drastic change in liquidity/volatility and position sizing.
Here are the bullet points with my opinion of whether each is positive or negative for bonds:
1. Economy (the economic data favors holding these positions)
Data points continue to show US, China and European economies continue to slow.
Companies are missing revenue and growth estimates which is why the S&P 500 is up just over 1 percent YTD. Companies are resorting to M&A and share buybacks to try to keep their stock momentum positive. With the economy slowing (late cycle) and 72 months into the expansion, it will continue to be difficult for companies to grow organically. Moreover, higher interest rate yields will already take a toll on the economy even without the Fed raising interest rates.
Yellen gave specific data points in her last meeting minutes. Jim Rickards (see Fed Minutes below) believes the data points are 5.2% for employment, 1.8% for inflation and 2.2% GDP growth. If those levels are obtained it is likely the Federal Reserve will raise interest rates. So where are we currently compared to those levels?
Unemployment: In the most recent employment report the jobs number was up (good) but because more people started looking for jobs the unemployment rate data point went from 5.4% to 5.5%. This decreases the probability of a rate hike.
Inflation: The Fed target is 2% so they could start to raise rates if it hits 1.8% and is trending up. According to the Bureau of Economic Analysis the overall PCE inflation rate for April was 0.3%, annualized. (source: https://www.dallasfed.org/research/pce/). That means that there is still plenty of room for inflation to increase before it rises to a level that would cause the Fed to act.
GDP: Target is 2.2%. The Atlantic Fed has a new calculator that was spot on what the actual Q1 15 GDP reading was. It is currently predicting that Q215 GDP will be 1.9%. (source: https://www.frbatlanta.org/cqer/research/gdpnow.aspx). This GDPNOW is based on reports to date but currently indicates that the economy needs to expand further before hitting their target level of 2.2% GDP growth.
Monday morning St. Louis Fed Bullard (dove wanting to raise rates) said “It is appropriate to think the Federal Reserve won’t raise interest rates at its June policy meeting following a recent run of weak economic data” and “I think it’s very difficult to say that you’re trying to normalize interest rates just at the moment where the economy looks a little bit weaker,”
And another data point today: “U.S. consumer confidence fell 1.7 percentage points in June, declining for the second consecutive month and to its lowest level this year, a survey released on Wednesday showed. (The Thomson Reuters PCSI comes out two days before the University of Michigan consumer sentiment index and independent testing has shown up to a 90 percent correlation between the PCSI and University of Michigan survey and up to a 93 percent correlation with the Conference Board Consumer Confidence Index.)
The next Fed meeting is Wednesday and I expect we will see prepositioning leading up to it. The yields on US Treasury bonds have continued to go up the last several weeks. There isn’t any way to know for sure, but it is likely that traders will begin to pre-position bets leading up to the Fed Meeting on Tuesday and Wednesday. I expect the Fed to continue their language that the economy is growing, but can do better and that they expect it to be better, etc. At the same time they will acknowledge that there are problems…play to both sides. But in the end they will be pushing out the dots which should be positive for yields coming down, helping these positions.
2. Liquidity/Volatility (the surge in volatility and lack of liquidity favors removing or reducing these positions)
European bond yields became very volatile in Feb and continue that way. It affects our bond market too. I believe that the recent surge in US bond yields is because of the European volatility as opposed to economic data in the U.S. That means that this volatility ‘premium’ could remain in our bond markets until European bond yields drop substantially. So this is negative for our positions. On a positive note, German Bund yields have dropped over 20% in the last two trading days. And the concerns over Greece should cause yields to guide lower.
Liquidity…the lack of available bonds (because so many owned by central banks), lack of market makers means that there are wider price swings in both directions. There can be significant moves overnight when the markets are closed so there is limited ability to protect the money in these downdrafts. Likewise, there can be times when the markets open significantly higher.
Volatility and liquidity issues may not be resolved any time soon. In highly manipulated markets it should be expected that volatility with remain higher than normal.
3. Position Sizing (favors continuing to reduce size over time)
Traditionally, TLT and EDV (bond ETFs) have not been as volatile as they have been since February. This resulted in me (in hindsight) having too large of a position relative to their new volatility profile.
My approach (as outlined in commentaries) was to endure the pain until the cycle reverses so I wasn’t selling at the worst time. Up until last Thursday, that has led to further losses because the liquidity issue is extending the cycle. That may be changing…
Footnotes:
From Fed Minutes: “The Committee agreed to maintain the target range for the federal funds rate at 0 to ¼ percent and to reaffirm in the statement that the Committee’s decision about how long to maintain the current target range for the federal funds rate would depend on its assessment of actual and expected progress toward its objectives of maximum employment and 2 percent inflation. Members continued to judge that this assessment of progress would take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. Members agreed to retain the indication that the Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reason-ably confident that inflation will move back to its 2 per-cent objective over the medium term.”
Thanks for reading.
Jeff’s Trending Indicators
US Stock Market Trending Down
US Bond Yields Yields Trending Down* (means prices go up)
Twitter: @JeffVoudrie
The author has positions in mentioned securities. Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.
