Back in February, with the unfortunate punctuality of a Swiss watch, we published an article exactly one day before the Russian invasion of Ukraine, signaling our idea to overweight longer dated government bonds as a tactical trade for a portfolio. At the time, US Government 10-Year Note yields were at 2.23%. Today they are at 2.75%…Ouch! While horrifically bad, they are down much less than Russell 3000 equities, our funding source. As always, we get that it’s tough to spend relative dollars.
Clearly, we underpriced the impact a Russian and Ukrainian war would have to global supply chains, despite being believers of longer-term structural deficiencies in global commodity supplies. We were betting that the economy was going to slow during the second quarter because of slowing demand and rising short-term interest rates. We believed buying into longer dated bonds, which were already in a deep bear market, provided an opportunity. I think we also clearly underestimated the full negative effects of the Fed withdrawal from the QE process. Investing is a humbling experience that shouldn’t be defining but rather educational; one must look forward. So where do we stand today on duration?
Longer term we are still skeptical of the value hypothesis for bonds, and we hold relatively few in our portfolios. After inflation and taxes, we do not believe longer dated interest rates offer a multi-asset portfolio enough return relative to the risk. Over the next decade, we believe the world will face higher prices because of a deficit of required commodities and materials needed for global infrastructure spending and consumption. Likewise, the shifting geopolitical landscape will diminish foreign countries interest in funding our current account deficit.
In the short-term, we stand by our call from back in February that for the next few quarters the economy is just now starting and will continue to experience a slowdown. We have been seeing this in real time since the beginning of the second quarter. The Fed is seeking to reduce the quantity of money in the economy, to fight inflation, and that should be supportive for longer dated government bonds. Over the past three weeks we have seen bonds rally as result. Is this a start of a new trend or are bonds bouncing after their worst sell-off on record?
To help us in our decision making we first look at our bond sentiment models which show investors are unsurprisingly extremely pessimistic. Q1 of 2022 was the worst quarter for bonds since the early 1980s. Traditionally investor sentiment is counter cyclical to bond yields, which makes it a good starting point. Bad sentiment by itself is not enough to pick a bottom, however.
We also can look at fundamentals, most simply the level of yields relative to the direction of real GDP and inflation. We already implied that we expect real GDP to fall as the Fed hikes short-term rates. However, while inflation is likely near or past its peak on a year-over-year basis, we only expect it to fall to about 6% by the end of the year, keeping nominal GDP higher for longer, and making it difficult for investors to rely on bonds for a portfolio hedge like they have in the past.
Looking at the existing deficit of energy and agriculture stockpiles going into the summer months, we have concerns that we still might not have seen the peak of inflation. If higher commodity prices prevent inflation expectations from falling, bonds could continue to sell off.
Finally, we can look at the technicals of the bond market. The trend is still down. According to Bloomberg data, TLT
We still don’t know what will happen in June when the Fed begins shrinking its balance sheet. Neither do we know at what point they will pivot, if at all, as higher interest rates begin tightening financial conditions. Tallying up the investor sentiment, fundamental and technical pictures, bonds are starting to look interesting for that tactical trade, however it is still early. Bottom picking is a dirty and dangerous investment process. For now, we will hold government bonds through the real GDP slowdown.