Source: Pexels/Tim Gouw – My long-term bond chart forecast
Those who read my work know I’m a big fan of the bond market. Even though I focus on international equity investing, I use the bond market as one of my primary investment signals and often have a direct position in treasuries.
Quite frankly, the treasury bond market is far less efficient than any other market. It is essentially fixed by global central banks. Statistically speaking, treasury bond price movements have a much higher degree of trend stability in trendy periods and mean reversion in ranging periods.
Now that bonds have seen a huge speculative-type rally, I believe the top is in or likely to be in soon for long-term bonds.
One fund investors can use to bet on higher long-term rates is the ProShares UltraShort 20+ Year Treasury ETF (TBT). For every 1% the 20-year treasury fund (TLT) falls, TBT is expected to rise 2% (on a given day). While the fund has taken a huge hit following the recent bond rally, I expect it to see stronger performance going forward.
The real fundamentals for long-term rates indicate much lower long-term Treasury bonds. Inflationary fundamentals are rising, retirees and pension funds are going to become net sellers very soon, and recently rapidly expanding U.S. government deficits are likely to eventually cause investors to demand a “money printing” premium.
Some readers may be thinking, “The coming global recession means a flat yield curve”. Remember, a yield curve flattening/inversion indicates a recession, and the reverse is the exact opposite. Most yield curve steepening occurs from the usually 18-month period between a curve inversion and recession, exactly where I believe we are today. Put simply, betting on higher rates may be the “trade of the decade(s)”.
Introduction to TBT
In case you have not already looked into the details of the fund, let’s go over them just so we know what exactly we’re looking at. Specifically, TBT holds U.S. 20 year+ treasury index swaps. Today, this is with four other banks, which make the fund’s counterparty risk very low. The fund has been trading since April 2008 and has been faced with a nearly constant decline in long-term treasury rates.
It currently has $640 million in AUM, which has been steadily trending lower since about 2011, when inflationary concerns first subsided. Take a look below:
Interestingly, the fund’s AUM is very close to its initial level when the ETF was launched. This may be a signal that the bearishness on the ETF may be hitting a maximum level.
Take a look at the fund’s price versus the 20-year treasury rate:
As you can see, the two track each other well, but the ETF does trend to trend lower even if 20-year treasuries do not. The fund does have an expense ratio of 80 basis points, which is a negative factor, but the other reason is known as “leverage decay“, which is a common problem in levered (specifically inverse levered) funds. That said, if there is a trend toward higher rates with low volatility, that “leverage decay” will actually generate excess returns via daily compounding.
Overall, TBT is a fine product to bet on higher long-term rates, but speculative traders in the ETF should not try to become investors. In other words, it does not make for a great long-term buy-and-hold no matter market conditions.
Inflationary Fundamentals Rising
The single most important factor for long-term rates is inflation expectations. If you expect inflation to rise, you’ll demand a higher return such that your return after inflation should be about the same. Today, market inflation expectations are low and are down a bit from the beginning of the year. That said, it is only a temporary factor due to the short-term rates being higher.
Long-term fundamentals indicate higher inflation soon. Most notably, wage inflation. Take a look at wage inflation versus core CPI inflation and inflation expectations below:
(Source: Federal Reserve)
As you can see, both core CPI and wage inflation are trending higher, while market-implied inflation expectations (derived by the difference between fixed-rate and inflation-protected 10-year treasuries) are falling. The core reason for this divergence is the decline in oil and agricultural prices last year. Of course, the Fed used it as an excuse to lower interest rates, but the core long-term inflationary fundamentals are rising.
When wages rise faster than core CPI, the purchasing power of the average worker rises. Over the past three decades, that has been largely untrue until today. As purchasing power rises, demand for stuff rises beyond supply and inflation rises. Indeed, this may become a feedback loop that ends with much higher rates, particularly if the Fed continues to disregard the fundamentals.
To see this on an even long-term level, take a look at wage inflation for the median worker versus average mortgage and car loan rates:
(Source: Federal Reserve)
It is inherently deflationary for these consumer lending rates to be higher than wage inflation. If a mortgage rate is higher than your expected income increase next year, borrowing today is expected to lower your consumption next year. If your consumption is lower the following year, then you will buy fewer expensive items and inflation will fall. In my opinion, this single fact is the major reason why inflation has been falling for the past few decades.
Now that consumers can borrow at a rate around equal to their wages, they will not be lowering future consumption and a long-term inflationary feedback loop can ensue.
In my opinion, once markets realize this, the yield curve will rip higher. Indeed, it would be a paradigm shift in the markets and reverse one of the largest trends of the past nearly four decades.
Yield Curves Steepen Before A Recession
While flat curves indicate a recession, they also indicate a steeper yield curve. In fact, a flat curve is a much better predictor of a steeper curve in the future than a recession.
Remember, yield curve steepening is likely to push TBT higher, since it is betting on higher long-run rates. Take a look at the yield curve over the past few decades:
(Source: Federal Reserve)
As you can see, an inverted yield curve tends to forecast recessions with a high degree of accuracy. The curve has inverted, so if history is any guide, we are likely about 6-18 months away from a recession. During this period, the curve trends to steep by about 1%.
Of course, interest rates usually fall during this period. Typically, the curve steepens as short-term rates fall far faster than long-term rates. That said, ongoing repo market volatility and inflation fundamentals signal that the Fed cannot lower rates much more without destabilizing prices. Remember, the Fed is mandated to keep prices and unemployment stable, not to keep bonds from falling. Today, the labor market is rock-solid and not deteriorating per usual before a recession.
If the labor market continues to be strong (which job vacancies and wage growth indicate they will), the Fed will have no valid reason to lower rates. Even more, they may not be able to safely lower rates without exacerbating the repo market funding problem.
Indeed, the curve may steepen and a recession may occur without a major drop in wage growth. This would imply a huge upward move in long-term rates over the coming months.
The Bottom Line
Overall, the economic signals indicate higher long-term rates. Short-term rates may have more downside, as the Fed may still push another rate hike (though I wouldn’t bet on it), but that would only serve to benefit long-term bond short-sellers, as it would accelerate the already rising inflation rate.
If you need yet another reason to sell bonds or bet on higher rates, remember the U.S. debt. The U.S. government deficit is continually rising faster than expected, due to a rise in healthcare costs (medicare/aid) and a surge in social security retirees (which also directly means treasury bond sales). Indeed, a $1 trillion deficit looks increasingly likely. About 15% of the government’s discretionary budget is going toward interest expense, and rates are at the lowest level in the history of the U.S. If they rise at all, the U.S. credit rating will almost definitely take a hit, which would mean much higher long-term rates.
Put simply, all fundamentals support TBT. While short-term central bank intervention may delay the inevitable, it cannot stop it, and in my opinion, their ability to delay the inevitable has fallen dramatically over the past decade.
Though it may seem extreme, I expect 20 year+ rates to climb back to the 4-5% range over the coming years and a sharp move of at least 50 basis points higher in the coming months. Though TBT is not well-suited for long-term holding, the short-run fundamentals are strong and I expect the ETF to rise back to $30 (25% higher) by year-end. To me, TBT is a clear short-term “buy” and long-dated Treasury bonds are an easy long-term “sell”.
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Disclosure: I am/we are long TBT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.