Bear Bond Market, Interrupted

April 9, 2018

Until the correction that began in late January, the stock market had marched upwardly unabated. Among the reasons for the unrelenting climb was that investors were being corralled into it. That is what happens when stocks are the only game in town. Although there are a number of investment vehicles, most folks pour their money into real estate, CD’s and money markets, bonds, and stocks. Real estate is getting pricey. Despite the recent Fed rate hikes, CD’s and money market accounts still yield a pittance. Then in early January stalwarts in the bond industry, particularly über guru Bill Gross, declared the beginning of a bond bear market. When Gross speaks, people listen.

 

Yes, equity prices are frothy, but a cooperative media, a smattering of good economic news, and a complacent public that does not want to miss out on the bus is a powerful combination despite President’s Trump’s recent tariff rhetoric. That too will pass as people realize this is Trump’s method operandi when it comes to negotiation and attention turns to earnings. According to Thomson Reuters data, these are predicted to rise 17.7% for the S&P 500. Some have touted this earnings season as the best since 2012, but a check of S&P 500 earnings by quarter in multpl.com shows Q2 and Q3 2017 were higher. Other than that, one would have to go all the way back to Q3 2011 to get a beat.

 

The bond market’s demise is understandable. The Fed is intent on removing monetary accommodation and raising rates. This makes sense. The Fed wants to stem easy-money-led bubble formation and inflated asset values, as well as prevent inflation from rearing its ugly head. If you question the current version of the Fed’s resolve, you need look no further than Fed Chair Jerome Powell’s comments this past Friday, April 6. Regarding the Fed’s goals of 2% inflation, sustained economic expansion, and a strong labor market, the Fed Chair stated, “my FOMC colleagues and I believe that, as long as the economy continues broadly on its current path, further gradual increases in the federal funds rate will best promote those goals.” For those thinking the Fed may wobble given the ongoing correction, Powell put the kibosh on that when he warned that raising rates too slowly would force the Fed to tighten monetary policy too abruptly down the road. Ostensibly, those steadily raising rates will force an increase in Treasury rates, which will spell an equally steady decline in Treasury prices, ergo the bond bear market prognostications.  

 

Then again, this reminds me of Mark Twain when he wrote, “The report of my death was an exaggeration.” I think the bond market’s demise is greatly exaggerated, at least in the intermediate term. What if the economy was to substantially deteriorate? Even a resolute Fed would have to eventually capitulate. Our present situation reminds me of Alan Greenspan’s equally resolute Fed back in 2007. Much like today’s Fed, Greenspan’s had embarked on a money tightening spree from June 2004 to June 2006. The Fed Funds and discount rates were increased from 1% and 2%, respectively, to 5.25% and 6.25%. Having achieved normalization, the Fed stubbornly held rates at those markers, despite signs of a weakening economy. That is, until their decision to stand pat on August 2007 roiled markets. This caused the Fed to capitulate a week later lowering the discount rate 0.50% to 5.75% and to start a loosening program.

 

I am of the mind we will soon get to replay the same scenario. As I have written previously[1], I believe we are witnessing the dawn of a severe and prolonged economic downturn. When its effects become apparent, the Fed will have no choice but to lower rates in an effort to prop up the economy. At that time bond prices will rally. But beware, not all bonds will, only the ones seen as a safe haven. 

 

As a result, only U.S. Treasuries and the highest quality corporate bonds will fare well in this market. Be forewarned, however, not to stay invested in these too long. My study[2] has shown that bonds will only outperform on the downslide portion of bear markets. Once the market begins to rally, bonds usually falter. Moreover, once the economy recovers, the Fed will likely resume a program of monetary policy normalization and remove accommodation. This will usher in anew the bond bear market.   

 

The following ETF bond funds would provide a good vehicle to profit from the short bond rally. I have only included the largest EFT’s, those with more than $1 billion total assets (given in parenthesis), since those are bound to be the most liquid. You will notice the list includes only intermediate- and long-term bond ETF's, since those will likely benefit most from the rally. The largest long-term bond is TLT.

 

iShares 7-10 Year Treasury Bond ETF (IEF, $8.46 billion)

iShares U.S. Treasury Bond ETF (GOVT, $5.51 billion)

Vanguard Intermediate-Term Treasury ETF (VGIT, $1.71 billion)

Schwab Intermediate-Term U.S. Treasury ETF (SCHR, $1.35 billion)

iShares 20+ Year Treasury Bond ETF (TLT, $7.11 billion)

 

There are a number of shorter term bond ETF’s such as SHY, IEI, BIL, and SCHO, but they have limited upside potential. On the other side of the spectrum, the more aggressive among you may want to turn to leveraged bond ETF’s. The problem with those is that the majority have fewer than $100 million in assets. Only TMF, Direxion Daily 20+ Year Treasury Bull 3X has more with $105.7 million in assets. Despite its small number of shares outstanding, 5.5 million, it still has a year-to-date average daily volume on par with its larger, unleveraged counterparts. Its 686,000 shares daily volume pales in comparison with TLT’s mammoth 10,500,000 or IEF’s 3,264,000, but it is not too far off GOVT’s 1,618,00 and way ahead of VGIT’s and SCHR’s 167,000 and 175,000, respectively.

 

 

[1] It's Not Over!, Karl De Jesus blog, megabearmarket.com, (https://www.megabearmarket.com...); It's Deja Vu All Over Again - Wanted: More Old Timers at the Money Helm, Karl De Jesus, March 23, 2018, Ezine Articles, (http://ezinearticles.com/?Its-...); And Then the Tempest – The Imminent Financial Meltdown is Real and What to do About it, Chapters 3 - 9, Karl De Jesus, Outskirts Press, Parker, CO, in press.

 

[2] Chapter 14, And Then the Tempest – The Imminent Financial Meltdown is Real and What to do About it, Karl De Jesus, Outskirts Press, Parker, CO, in press.

 

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