Long bonds are past their best
Over the last few days, article after article have been saying that this year’s decline in US long term rates was totally unexpected, and that the behaviour of the bond market has prompted many financial firms, and even the US Federal Reserve, to throw away the econometric models they used to forecast long rates.
Throwing away econometric models and realising that making accurate forecasts with any degree of consistency is impossible—just look at the Fed’s forecasts for the US economy over the last few years—has to be a step in the right direction. At the beginning of this year, the consensus was overwhelming that long rates had only one way to go: up. Out of 68 economists polled by Bloomberg on the future behaviour of long rates, all 68 predicted a rise. Now, whenever 100% of economists expect something to happen, alarm bells should sound alerting you that the exact opposite is about to happen. Sure enough, it did.
However, in a series of research notes since September last year analysts have advocated buying long US treasury bonds as a hedge against US equities.
The real enemy of the bond market is inflation. According to Wicksellian research, whenever the cost of money for the private sector is more than 200bp higher than the growth rate of US GDP, then the US inflation rate goes on to fall. The reason is simple enough: when the cost of money is more than 200bp higher than the growth rate of the economy, it does not pay to borrow. The velocity of money falls, and with it the inflation rate.
Now, let’s look at the behaviour of the bond market itself. If bond yields are up by 30% or more over the previous 12 months, then the bond market is oversold and one should expect a “reflex” rally.
The first condition was met in September 2013, with the real rate on long-dated industrial Baa bonds going on to reach a peak of 240bp over GDP growth. The second condition was met at the end of August 2013.
Every recession since 1960 occurred when the Baa bond rate was 250bp or more above the GDP growth rate. We came within a whisker of that point over the last few months-which, along with the wintry weather, may help to explain why the US economy contracted at a 1% annualised rate in the first quarter of this year-but we never reached it (while all recessions have occurred with the Wicksellian spread above 250bp, not every occasion when the spread has surpassed the threshold has led to a recession).
So, from September 2013 to January 2014, we had a very attractively priced long bond, which was also very oversold. As a result, we issued a buy recommendation.
Where are we today? In a neutral position. Baa bond yields have declined to a point where the spread between the bond rate and GDP growth is below 200bp-at 110bp-and the bond market is neither oversold nor overbought. Bond protection would make sense in your portfolio if we were heading into a recession, but that seems unlikely given the low Baa rate. However, owning bonds could still have some merit on a valuation basis and as a hedge against disturbances in an overexcited stock market.
But the time to load up on long bonds was in the fourth quarter of 2013.