Here’s a strange thought from Jeff Gundlach, one of the world’s largest bond managers:
“If you get above 3%, then it’s truly, truly game over for the ancient bond rally.”
And here’s Bill Gross from earlier this month:
Gross: Bond bear market confirmed today. 25 year long-term trendlines broken in 5yr and 10yr maturity Treasuries.
— Janus Henderson U.S. (@JHIAdvisorsUS) January 9, 2018
This is super interesting. In essence, two of the world’s most famous bond managers are making massive secular bond calls based on…lines on a chart?
This raises a couple of important questions: 1) what is this theory of inflation? And; 2) does inflation (and therefore bond prices) display momentum? These are big questions so let’s think about this some more.
Now, the interesting thing about using charts to read the bond market tea leaves is that it implies that interest rates are primarily a momentum phenomenon. In other words, when interest rates break X% then there’s a probability that they will continue higher or lower. As I’ve noted before, momentum works in an equity market index fund for fundamental reasons – the fund is essentially a rules-based product that sells losers and buys winners thereby attaching itself to long-term growth in corporate profits. But should momentum work in the bond market?
What Drives Bond Prices?
First, let’s look at a simple example of stocks and bonds. Stocks have momentum in the sense that corporate profits are generally rising. An equity instrument is attached to that stream of increasing income. An equity index fund is a rules based system that always maintains exposure to this growing pie of income. Therefore, it exhibits momentum.
A bond is an instrument with a fixed income stream. A high quality bond exhibits momentum for the same basic reason that the equity market index fund does – it has reduced risk of permanent loss because the instrument is designed not to expose the investor to credit risk. So, the equity market index fund sheds losers before they become losers which creates a high probability of positively asymmetric long-term returns. Likewise, the high quality bond is an inherently safe instrument with low principal risk paying a steady stream of income. But when we analyze bond returns and the risk of owning bonds at current rates we aren’t trying to analyze whether that bond will have momentum. We really want to know if interest rates have momentum because we want to analyze the real opportunity cost of buying bonds today versus buying bonds later.
It’s important to note that interest rates and inflation are very highly correlated. So, as inflation rises bond investors will demand higher yields to protect their bond purchases from purchasing power erosion. If interest rates have upward momentum then the opportunity cost of waiting to buy bonds will likely be positive in real terms. Inflation is very difficult to predict which makes future interest rates very hard to predict. So, if interest rates are largely a function of inflation expectations can we predict future rates of inflation (and thus interest rates) by looking at charts and momentum?
To understand if interest rates have momentum that can negatively or positively influence bond prices we have to expand on my initial assumption above – that inflation expectations are the main long-term driver of bond prices. Let’s use a AAA rated 30 year T-Bond for simplicity so that we know the credit/liquidity/call/duration risk. Based on this assumption we are pretty much left with inflation risk when we’re analyzing how the bond will generate its returns. So, for a high quality bond, if you can predict the future rate of inflation you will have a pretty good idea of the risk adjusted real returns of your bond because you’ll have a good idea of where future interest rates will be.
Do Interest Rates Have Momentum?
Here’s an old(ish) paper from the Richmond Fed discussing momentum in inflation. The paper shows that inflation does indeed tend to have momentum, but remains an incredibly difficult thing to predict. Part of what makes it difficult to predict is that forecasters tend to rely on short-term factors that overlook the fundamental long-term macro forces that really drive interest rates. Importantly, the momentum tends to operate over very long time periods as inflation often rises slowly then quickly. Likewise, disinflation can be a slow event as we’ve seen for the last 30+ years. There does indeed seem to be some momentum in the big secular trends that drive inflation and therefore interest rates.
But here’s the problem I have with what I’d describe as “chart crimes” by Gundlach and Gross – if they’re predicting the end of the bond bull market then they’re relying on a theory of inflation that basically amounts to long-term secular trends ending just because a short-term trend line on a chart was broken. There is no evidence to support such thinking. It might look cute on a picture and make for good soundbites, but this is not an empirically supported theory of inflation, bond pricing or interest rate changes.
Revisiting the Widowmaker
The Japanese Government Bond has been called the widowmaker trade for much of the last 30+ years as investors tried to short bonds assuming that aggressive monetary and fiscal policy in Japan would cause high inflation. But yields continued to plunge lower and lower. You could have drawn lines on charts for 30 years finding trendline breaks in the short-term that were short-lived because the macro forces of disinflation were reinforcing.
This brings us to the important point here – drawing short-term trend-lines on charts is a form of short-termism that confuses short-term market trends for long-term secular trends in the real economy. In other words, long-term secular trends in inflation aren’t necessarily changing just because some short-term trends on interest rate charts were broken. This analysis is putting the cart before the horse in that the secular fundamental trends drive the lines on the chart and not vice versa.
Inflation is More Complex than You Think
Predicting inflation is really hard. I’ve done an okay job over the last 10+ years mainly because I understood that QE wouldn’t result in bank reserves “leaking” out into the economy and causing the money supply to increase. Now that QE is winding down and the economy is stronger the future rates of inflation are going to be somewhat more difficult to predict. Still, I think we can make a few safe projections:
- Inequality is on the rise and regulatory changes are giving the working class less wage negotiating power.
- Technology and automation advancements are inherently disinflationary.
- Demographic trends mean the economy could continue to be relatively weak as the immigration and growth trends don’t favor strong real growth.
- Balance sheets remain relatively weak and are consistent with low growth in credit (the real money in the economy).
Based on these secular macro trends the odds are low inflation for longer. This is supported by the evidence showing that inflation tends to be reinforcing with momentum in the long-term. That doesn’t mean inflation can’t move a little higher from here (bond traders will overreact and do what traders do), but calling for an end to the bond bull market is essentially the same as saying that inflation is about to move much higher and that all of those big macro trends are about to reverse. That might be right, but a short-term trendline on a chart isn’t going to tell you that.
There is little to no evidence showing that a momentum strategy will help you make short-term predictions about the fundamental secular macro trends that drive interest rates. In fact, if anything, inflation and interest rates tend to exhibit long-term momentum that becomes reinforcing. Using short-term trends to decipher long-term momentum is unlikely to be a useful way to predict future bond prices.