Back in February, unfortunately, due to the punctuality of Swiss watches, we published an article the day before Russia invaded Ukraine, indicating that the idea was to add long-term government bonds as a tactical trade in a portfolio. At the time, the yield on the 10-year US government bond was 2.23%. Today they are 2.75%… oops! As bad as they were, they fell far less than our funding source, the Russell 3000 stocks. As always, we know spending relative dollars is difficult.
Clearly, we underestimate the impact of the Russia and Ukraine wars on global supply chains, even though we believe there are long-term structural deficiencies in global commodity supply. We are betting that the economy will slow in the second quarter due to slowing demand and rising short-term interest rates. We think there is an opportunity to buy longer-term bonds that are already in a deep bear market. I think we also significantly underestimate the full negative impact of the Fed exiting the QE process. Investing is a humble experience that should not be defining but educational; one must look forward. So where do we stand today on duration?
We remain skeptical of bond value assumptions over the long term, and we hold relatively few stocks in our portfolio. After inflation and taxes, we do not believe longer-term interest rates will provide adequate returns relative to risk for multi-asset portfolios. Over the next decade, we believe the world will face higher prices due to shortages of goods and materials needed for global infrastructure spending and consumption. Likewise, the changing geopolitical landscape will dampen foreign interest in funding our current account deficit.
In the short term, we stand by our call back in February that the economy is just getting started and will continue to slow over the next few quarters. We’ve been seeing this in real-time since the start of the second quarter. The Fed is looking to reduce the amount of money in the economy to fight inflation, which should support longer-dated government bonds. Over the past three weeks, we’ve seen bonds rally as a result. Is this the start of a new trend, or is bonds rebounding after the worst sell-off ever?
To help us make our decision, we first look at our bond sentiment models, which, not surprisingly, show that investors are extremely pessimistic. The first quarter of 2022 was the worst for bonds since the early 1980s. Investor sentiment and bond yields have traditionally been countercyclical, making it a good place to start. However, bad mood alone is not enough to bottom out.
We can also look at fundamentals, the simplest being yield levels relative to real GDP and the direction of inflation. We have already hinted that we expect real GDP to fall as the Fed raises short-term interest rates. However, while inflation may be near or above its peak year-over-year, we expect inflation to fall to around 6% by year-end, with nominal GDP remaining elevated for longer, and investors struggling to afford to rely on bonds for portfolio hedging as they have in the past.
Given the existing shortages in energy and agricultural inventories heading into the summer, we are concerned that we may not yet see a peak in inflation. Bonds may continue to sell off if rising commodity prices prevent inflation expectations from falling.
Finally, we can look at the technicals of the bond market. The trend is still going down. According to Bloomberg data, TLT
We still don’t know what will happen in June when the Fed begins to shrink its balance sheet. Nor do we know when, if at all, they will turn as higher interest rates begin to tighten financial conditions. Combining investor sentiment, fundamentals and technicals, bonds are starting to look attractive for this tactical trade, but it’s too early to tell. Buying the dips is a dirty and dangerous investing process. For now, we will be holding government bonds in the face of a slowdown in real GDP.