What About Bonds?

Bond yields have risen. As we discussed in An Epic Bond Bear Market, this is about all the mainstream financial media have to say about bonds. Glossed over is the fact that bonds have prices too. Stocks, in contrast, have prices but not yields. Thus if stock prices fall, the fact that their yields rise is lost in most reporting. Conversely, if bond yields rise, that their prices fall is usually relegated to an asterisk or parenthetical phrase.

The bond market is a full on grizzly bear. Let’s take a look at an updated chart of the broad Treasury market fund, GOVT. This fund covers bonds from one to thirty years maturity. Due to weighting being concentrated in the shorter maturities, price fluctuations are typically mild. It’s a widows and orphans kind of thing. But not recently.

Bloomberg reports that the long term Treasury fund TLT is down a record 48% since its 2020 high. A similar decline in the S&P 500 would be treated as apocalyptic.

What’s driving this? If you follow the mainstream narrative, it’s all about the Fed. The Fed has been telling us to plan for higher for longer. Never mind it’s been saying that all along … for reasons that shall remain a mystery, the markets have only in recent weeks decided to believe it.

Oh … and never mind the laws of supply and demand. The torrent of deficit-driven supply issuing from Treasury is unrelated political noise.

So once again Financology dons its green eyeshades of skepticism when it comes to the mainstream narrative. I think it has a lot more to do with supply and demand than said narrative lets on. It simply takes higher yields and lower prices to fund borrowing that exceeds a trillion dollars just this quarter. 

This isn’t to say the Fed is irrelevant. At however glacial the pace, it has been shrinking its balance sheet. The gist of it is that the Fed could monetize this flood of Treasury debt. And it’s under enormous pressure to do so. It is resisting this pressure because the pressure not to exceeds it …so far … after years of accumulating in asset prices, the asset tank is full. Inflation has been overflowing into consumer prices and wages.

Fed ease “works” by spurring borrowing. When rates are cut, it becomes cheaper, making it more attractive to borrow. Dollars are lent into existence, increasing the money supply and driving its value lower. It takes more dollars to buy the same stuff; prices rise. This appears first in asset markets trading tick-by-tick in real time. It later filters through the pricing chain into consumer prices.

But through ignorance, willful or otherwise, inflation is not acknowledged as such while it’s still confined to asset prices. It’s called “growth”. Only when it starts affecting consumer prices is it recognized as inflation. But it’s been inflation all along.

Fed tightening works the other way around. It makes borrowing more expensive. Less money is lent into existence, and money that has been previous borrowed is more quickly repaid, shrinking the money supply and inducing deflation. This similarly first appears in asset prices, later in consumer prices. Hence the storied “long and variable lags”.

What is happening now? The debt retrenchment has so far fallen entirely on the private sector. Corporate debt is under pressure, notably in commercial real estate. Fewer home mortgages are being taken out. Car loans. Credit card debt first surged as consumers fell under pressure, but it is now falling under the influence of gravity too. There is no infinite supply of money to simultaneously satisfy the demands of Treasury, corporate borrowing, home buyers seeking mortgages, car buyers financing purchases, credit card consumers, etc. 

Public sector debt has not yet begun to respond.

The number of paths forward is finite. Government debt will at least begin to grow at a slower pace or the full brunt of retrenchment will be borne by the private sector. Or the Fed will monetize the debt, again driving the dollar lower and inflation higher. There will be a hard landing or inflation will go higher. There are no other options.

Rock meets hard place.

19 thoughts on “What About Bonds?

  1. jk says:

    you forgot to mention the possibility of a hard landing AND inflation goes up nonetheless.

    1. Bill Terrell says:

      Aye … all of the above is the most likely outcome, as policymakers try to have their cake and eat it.

      They may come in sequence … inflation gives way to deflationary hard landing, which is then met with a reflationary blitz. The core point is there is no scenario in which none of these things happen. There will be no soft landing in which consumer inflation just quietly fades away while stocks continue to inflate. The cynic in me thinks the media are peddling this fantasy to give the big money time to offload their stocks to us retail plebs at premium prices before the bottom falls out.

      1. Bill Terrell says:

        The part about prices and yields across stocks and bonds has implications too. From their post-2020 lows, the yield on the cap weighted Treasury market has gone from the neighborhood of under 1.5% to over 4.5%. In the same time frame, the yield on the S&P 500 has gone from about 1.2% to 1.6%.

        This leaves stocks with a bit of catching up to do.

      2. Milton Kuo says:

        >The cynic in me thinks the media are peddling this fantasy to give the big money time to offload their stocks to us retail plebs at premium prices before the bottom falls out.

        I might have thought that during the housing bubble but I think the Federal Reserve and the government have seriously screwed things up so badly this time that I’m not convinced that the institutional investors are looking to cash out. I’m sure they’ll cash out of utter garbage and hyper bubbles (NVIDIA, Tesla, etc.) but I’m less certain about even stocks that are obviously overpriced such as Apple and Procter & Gamble. I suspect they, too, are seeing the USD as a risky asset.

        Jeremy Grantham said maybe two or three years ago about what a person should be invested in in this super bubble. He mentioned emerging market value stocks as the asset class that will probably give the best return but what really caught my attention is when he said something like, “going to cash should work.”

        I wish the interviewer had asked why going to cash wasn’t certain to work (it would if the USD were a truly hard currency) but I suspect Grantham is maybe thinking that reflation will be so fast that people in cash will never be able to deploy it and will have to continue to accept lousy returns, that the “hell scenario” GMO wrote about some years ago comes to pass (no crash, just abysmal returns for a decade or two), or maybe destruction of the USD.

        I hold more equities than I like because of this risk (dollar destruction) and it was also a reason why I participated in Eastham Capital’s newest fund even though I felt that prices for apartment complexes have gotten ridiculously expensive and the Eastham fund might end up having a fairly poor return.

        1. Milton Kuo says:

          I should add that maybe Grantham said, “going to cash will probably work.”

          In any case, it was very troubling to hear such a statement. 🙂

          1. Bill Terrell says:

            Glad you mentioned that, Milton. This post doesn’t really address strategy. I support the “cash” view. FWIW I’m still holding bonds via GOVT, but balancing it with SHV. The latter fills in the one part of the yield curve GOVT omits, the 0-1 year shortest part, shifting the maturity spectrum a little shorter. This has the dual benefit of reducing volatility and capturing the highest yields (well over 5% from 0-2 years).

            SHV isn’t quite cash, but moves so little with yield changes that the overwhelming feature on price charts is the monthly fluctuation as it accumulates and distributes interest.

        2. Bill Terrell says:

          As a devoted diversifier, I didn’t intend to imply all cash, rather a higher than normal allocation. I continue to have sizable allocations to stocks, bonds and commodities, mostly for the reasons you articulate. In fact most of my investments aren’t held for eventual sale, but for income, and the time frame mandates a defensive position with regard to inflation, the biggest threat to long term income. (Basically it’s the Income V portfolio discussed under Model Portfolios.) Of course most is not all, and the assets I do eventually intend to liquidate are structured for potential deflation, where I’ve stepped up the short term (near cash) Treasury allocation.

          FWIW, I also like residential real estate, although I use publicly traded REITS for this purpose, if for no other reason than they integrate with other investments in a brokerage account.

          So the tension between inflation and deflation protection boils down to time frame. Over the next year or so, a deflationary crash is a big enough risk to hedge for; beyond that inflation is the bigger threat.

          1. Milton Kuo says:

            >As a devoted diversifier, I didn’t intend to imply all cash, rather a higher than normal allocation. I continue to have sizable allocations to stocks, bonds and commodities…

            My understanding is that you are running some sort of variant of the Permanent Portfolio. I am, too, because what happens in the markets is dependent on the whims of highly placed, highly incompetent, and highly corrupt people.

            Going to all cash worked very well in the crashes of the dot-com and housing bubbles. However, I think the Fed reactions to the seisms in the U.S. bond market and the subsequent COVID mess demonstrate that going to all cash this time around could result in a terrible loss of purchasing power for those not nimble enough to jump back in to assets. That is to say, I don’t think there’s anything the Fed won’t do to prevent a full mean reversion.

            1. Bill Terrell says:

              It’s inspired by the Permanent Portfolio for sure. I think of the PP itself as a sort of simple approximation of the Global Market Portfolio, and what I do as a sort of hybrid. The Capital Portfolio on the Model Portfolios page is that part of it, the part where I dynamically allocate. The majority though is in Income V, where the focus is, well, income. Because that part isn’t earmarked for eventual sale, I don’t care so much about what happens to capital value. I don’t refer to it often because most investors are capital oriented … that is, they intend to eventually sell off assets. The concept behind the income approach is discussed in Financology Model Income Portfolio.

              You nailed the all cash problem. It depends a lot on getting the timing of two decisions right. As it happens I did manage to get one right in October 2002, but that was on the advice of my psychic rock drummer cousin who has since refused to further prognosticate…

              1. Bill Terrell says:

                You might find the psychic drummer story amusing. One day in the mid-late 1990s, my rock drummer cousin from Pennsylvania was visiting us in Virginia. We had been investing in mutual funds and got to BSing about the markets. After giving my high-falutin analysis, I asked for his thoughts. He stared up at the ceiling, reflected, and spoke slowly; “… July 1998 … March 2000 … October 2002”. My wife wrote the dates down a blue Post-It and stuck it on the side of the refrigerator.

                There it went forgotten for several years. One day in early 2002, my wife was cleaning around the fridge and discovered the Post-It. The first two dates had already passed. Both were significant market turns. July 1998 was the crash associated with the Russian financial crisis and LCTM debacle. March 2000 was when the dotcom bubble topped out. Having been in all cash for most of the bear to that point, I figured the remaining third and final date must be when it will bottom. We opened a brokerage account on October 1 2002 and started putting everything into dirt cheap real estate and energy stocks. I’ve thanked my rock-drummer-market-savant cousin for the early retirement, but I think it spooked him, because since then he’s not giving any more dates…

                1. Milton Kuo says:

                  That’s quite a story! 😀 Thanks for sharing it.

                  Does your cousin have any sort of study or experience in economics or financial markets to have called out such seemingly out-of-nowhere dates?

                  I cannot imagine anyone not heavily involved in the markets in some way being able to predict the Long Term Capital Management wipeout. I can’t help but wonder if your cousin perhaps was thinking: 1. Crash in 1998 2. Bottom reached in 2000 (stocks are cheap) 3. Markets at nominal prices (stocks no longer cheap) in 2002.

                  Grantham and GMO made a mistake on the timing and exited technology stocks in 1998.

                  I wish I had an interesting story to share for that period of time but, alas, I wrongly thought I would be able to exit the bubble before it crashed. The only thing I did get right was to invest practically everything I had into the stock market in 2002 when Alan Greenspan kept talking about his fears of deflation in the economy. I knew he was up to no good.

                2. Bill Terrell says:

                  He had no prior financial background. All he’d have had was my little spiel just before I asked for his thoughts. But that couldn’t explain it … I couldn’t have come within a light year of his list of dates. He is very intuitive though, dare I say psychic, and as a world class drummer had a highly developed sense of rhythm.

                  This was in or around 1996. He didn’t say anything about what would happen … just the three dates: July 1998 … March 2000 … October 2002.

                  My only credit was from having been in cash by the time the third date was approaching, and surmising that since the first two dates had turned out to be significant that the still-remaining third might be too. We’d started investing in mutual funds in ‘93. In ‘98-‘99 we sold off all the mutual funds to pay off the mortgage, having concluded we were effectively speculating on stocks with borrowed money. Plus valuations were too high and there was too much excitement for it to last; by early 2000 office coworkers had an email group all about the hottest tech and telecom stocks. They included me until I replied to one with a list of PEs lol.

                  By early 2002 we’d just started back into mutual funds when my wife showed me the note. Back to all cash until October.

                  You comments about knowing when to get back in reminded me of the story. Aside from my cousin’s list of dates, I had no clue. I eked out some damage control in 2008 only because of EJ’s legendary call at the end of 2007, but stayed much too cautious much too long afterward.

                  Market timing is hard!

                3. Bill Terrell says:

                  I hold Greenspan largely at fault for the wreckage since the turn of the century. In the late 1990s bubble he was the guy standing next to the tank of helium. Intoning “productivity…” he ignored inflation burgeoning in asset prices just because consumer price inflation was tame.

                  Then when that bubble imploded, he took to the monetary helium again to inflate a mortgage bubble. When that imploded, Bernanke doubled down with his “2% inflation target” and “wealth effect”. Still, the damage could have been contained were it not for “go big” Yellen maintaining crisis era accommodation years after the crisis had passed, inflating another bubble and luring politicians into exploding debt. Since Volcker, each Fed Chair was dumber than the one before.

                  Until Powell .., where the jury is still out…

  2. jk says:

    i think you’re right about keeping the market pumped to allow the big money to hand off their overpriced assets to the retail plebs. i always wondered about the reality of such maneuvers, but it was documented for me in the treatment of “mark blum” [steve eisman] in the big short. their cds’s kept being marked at low prices until the big banks made their own adjustments.

    1. Bill Terrell says:

      Now that your 6% Fed funds is within sight, Jamie Dimon ups the ante. Barron’s reports he’s floating 7%.

      That seems quite a stretch. More likely the stock market collapses first. On the other hand a year ago I would have thought 5.5% was a stretch…

  3. Bill Terrell says:

    In fairness I just heard a Bloomberg analyst, Garfield Reynolds, connect the dots between the ongoing surge in Treasury yields and “intractable deficits”. This was in the context of other numerous and repeated stories citing the Fed’s “higher for longer” stance and shutdown hype in connection with higher yields, so I’m not about to declare a media epiphany, but it’s a step…

  4. Bill Terrell says:

    The bulk of mainstream reporting on the carnage in the bond market continues to focus on the increasingly outdated narrative that it’s being driven by Fed expectations. But analysts are coming around to my view that government deficits are increasingly driving it. Three examples from the past few days:

    Shutdowns Come and Go. Why Deficits Pose the Real and Present Danger.

    Government Shutdown Averted. But Is That A Good Thing?

    The Wall Street Journal
    Rising Interest Rates Mean Deficits Finally Matter