The upcoming revival of the bond market
The capitulation is in full progress which finally presents the opportunity to reverse some of the enormous underperformance of recent years.
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
This article is entirely free to read.
Whenever I have written about bonds over the past year, I wasn’t very kind. I viewed it as an overcrowded market segment with a bull case predicated on an erroneous macro assessment. Here is a selection of some articles touching on the topic:
Over the last twelve months, TLT 0.00%↑ - the main ETF for long dated Treasuries - is down 15%, while the S&P is up 21%. Such a divergence rarely happens and when it does it typically occurs after distinct market bottoms such as 2003, 2009 or 2020.
Imagine you were a professional money manager and you had to explain why you have held a significant position in bonds during that period which guaranteed your underperformance. That’s certainly no fun. And with the current inflation echo, such a position might become an actual career risk. Do you really want to hold long duration bonds during their seemingly inevitable run beyond their October 2023 peak? I believe that is the main driver for the current positioning and sentiment shift.
This shift is the catalyst to finally resolve the issues of the bond market. When I say bond market, I typically focus on the US treasury market. However, most of the arguments pertain to all other types of bonds as well because the US treasury market is their pacemaker. About 10% of all debt in the world is owed by the US Treasury.
Once these issues are resolved, bonds may present an interesting long opportunity, especially considering that a maturing equity bull market comes with higher risk that wants to be hedged through diversification.
TLDR Summary
To invest into a treasury bond, an investor requires compensation for a) bearing inflation and b) foregoing productive asset returns should the economy do well. As a result, long dated treasuries typically compound at a rate equal to nominal GDP growth. This relationship is empirically proven and it has a justification that is theoretically sound.
While period over period correlation is unstable, bonds should over time also compound alongside stocks because stock returns are also a function of economic growth. However, stocks should outperform bonds because stocks compensate not just for bearing interest rate risk, but also for many other risk factors.
Over the past two years, bonds have underperformed their expected return against GDP and stocks by a huge margin. This happened because a sizable bubble had inflated in the bond market subsequent to the ultraloose monetary policy in the 2010s. The deflation of this bubble was slowed down by a massive duration bid that unfolded subsequent to the Fed’s hiking campaign. But two capitulation waves in the fall of 2023 and the spring of 2024 seem to have finally broken this resistance.
Investor positioning and sentiment data suggest that the capitulation is in full progress. As a result, bonds will likely soon enter the ‘hate stage’. After a bubble bursts, the asset class gets neglected by investors which typically provides for superior risk-adjusted returns for a while. Think for example about oil & gas after 2020, real estate after 2010 or technology after 2003.
As I have outlined recently, the revival of the bond market will likely receive aid from fiscal policy. Smaller deficits will ease inflation pressures and reduce debt issuance which should help bringing rates down. I believe that this process will be very slow and gradual because there is a lot of economic potential waiting to be unleashed by rate cuts. I expect a bull steepening where the front end of yields comes down quicker then the long end. Such a scenario should in fact be decent for bond investors as it will enable them to compound at higher rates for longer.
I still believe stocks will continue to outperform bonds in the long run. But from a tactical perspective, it may make sense to rotate some funds into bonds soon. The bond beta against the stock market is historically high at the moment. But I believe this will likely normalize when bonds leave their panic territory. Not every stock market dip will be a rate scare from here. Historically, bonds have done a decent job at reducing portfolio volatility through low correlation with stocks. I will likely lean into this asset class going forward to improve my ability to take on leverage.
The composition of investment returns
Investing is about bearing risk. Before an investor chooses an asset or an asset class to invest in, they need to decide what kind of risk they want to bear, i.e. what risk is likely mispriced and presents an opportunity to earn superior risk-adjusted returns.
The fundamental pacemaker for all kinds of nominal asset returns is liquidity growth which is determined by public and private sector borrowing. This liquidity drives GDP. If the productivity of this liquidity is high, GDP will grow faster and vice versa.
Based on this foundation, the risk menu to choose from is vast, including interest rate/duration, political (both geo and domestic), demographic, competition, technology and business cycle risks.
The more risk the investor takes on, the higher their expected returns and volatility will be. The three main asset classes to choose from include cash, bonds and equities. In this analysis, I define equities in a very broad sense, including real estate equity for example.
Of these three asset classes, cash has the lowest expected return, typically significantly below GDP growth. Denominated in its own currency, it has zero volatility by definition which makes it earn the so called risk free rate only. In theory, this risk free rate is primarily a function of (expected) inflation. In practice, Jerome Powell sets that for you arbitrarily depending on what data he feels like focusing on at any given point in time.
Long term government bond yields are typically equal nominal GDP growth. This relationship is empirically proven and it makes sense from a theoretical perspective.
The higher nominal economic growth, the more compensation bond investors will demand for bearing a) inflation to the extent nominal GDP growth significantly exceeds real growth and b) opportunity costs associated with foregoing returns in productive assets. In contrast to the bond investor, the cash investor has the option to deploy capital into the stock market anytime if the economic picture improves. They pay for this option through the term risk premium between cash and bonds. This term risk premium is currently negative, but it’s usually positive.
Equity returns typically outperform nominal GDP growth. Market valuations typically rise with nominal GDP because corporate free cash flows do the same. But along the way, companies distribute their current profits as dividends which can be reinvested by the investor.
The chart below illustrates how GDP, the S&P and the bond market (in the form of the 10-Year Treasury) have compounded since 1962. As you can see, the S&P price index and the 10-Year Treasury Total Return are advancing approximately in line with GDP while the S&P Total Return rules them all.
With all this context, we can divide the expected returns of each asset class into three buckets as follows:
Recent bond performance vs. GDP
Now that we have established that the bond market should compound at the rate of the GDP, let’s check out how both have done against each other. The chart below plots the 10-Year Treasury Total Return divided by US GDP. If this curve rises, it means bonds are doing better than they should vs. the economy and vice versa.
The bond market performed very poorly in the 1960s and 1970s because of raging inflation. This drove up GDP, but bonds did not participate proportionately because of their duration. They were locked into low coupons for too long. Framed differently, the bond market had underestimated inflation all the way from 1962 to 1982. By the way, treasury bonds were the main savings vehicles for US citizens during that time. Passive stock investing had not yet been established. Unsurprising that it did poorly, isn’t it? Markets always want max pain.
Then a huge generational bond bull market started. Inflation was under control and inflation expectations fell. Duration exposure paid off big time. This paradigm finally ended in 2021 which the biggest unexpected inflation surge since the 1970s.
When will the bond market finally have priced in inflation risks properly so that the risk premium in long duration bonds is sufficient to pay off in the form of positive risk-adjusted excess returns? We don’t know yet. But with every quarter of underperformance vs. GDP that passes, the probability rises that we will eventually get there. Mean reversion is the second law of the market constitution (after max pain).
Recent bond performance vs. stocks
Carrying out a similar analysis for bonds vs. stocks looks like this:
From 1962 to 2019, the stock market outperformed the bond market by about 3.5% annually. The average dividend yield during this period was 3%. If you think the proximity between those two data points is a coincidence, please reread the first section of this article. ;)
From 2020 to today, the S&P Total Return has exceeded the 10-Year Treasury Total return by 15% annually!
I believe that the US stock market will continue to outperform the US bond market in the long run. The fundamentals are strong based on an assessment of the demographic, technological and natural resources environment. However, a cyclical relative bounce of bonds vs. stocks appears overdue.
Capitulation in progress
I did cover the recent asset rotation already in detail in my April 2024 Market Strategy article.
However, I do want to provide an addendum because I was finally able to source the most important chart from the Bank of America Global Fund Manager Survey, which is the asset class positioning vs. history:
I want to illustrate the importance of this chart by asking you a question: Which of the following two requests will give you better insight into aggregate asset allocation?
Tell me your current weight in bonds vs. your benchmark.
Tell me your current weight in bonds vs. your historical weights.
The answer is the latter, of course. Benchmarks can change based on preferences of both asset managers and their clients. If clients are asking for certain asset classes more than in the past, the relevant investment products will have larger inflows. This may become overcrowded, but won’t necessarily show up in weights against benchmarks. It will however show up in weights against historical averages. And that is why it matters.
Now, asset allocations may of course change over time for good reasons. Certain sectors like technology or healthcare become more relevant due to innovation in those sectors and demographic trends. But much of these swings is also driven by cyclical swings with the tides of investor moods. That is why this chart has such a tremendous predictive power for forward returns.
Let’s look into the April 2024 version in detail. There is a lot to unpack:
The bond weight is still huge, about 1.3 standard deviations above its historical average since 2003 (when this survey was launched). But it has come down big time. Just a month ago, it was at more than 2 standard deviations. And during the peak times of the bond mania, it was at 3 standard deviations.
The take from this is not straight forward. Such an overweight against historical levels suggests continued underperformance. However, I believe we will likely not go to extreme historical underweights for the foreseeable future because about half of the historical sample was the ZIRP age in which bonds were not a suitable investment alternative for many investors. They chose dividend stocks in their hunt for income.
One thing is however certain: There is a major capitulation of bond investors going on right now. They are finally dumping bonds to allow the bond market to puke out its 2010s excesses. And as I have predicted, they are not converting their bonds into cash. Cash is in fact the most hated asset class. Instead, they are chasing cyclical assets, some of which are now showing up far up in the asset ranking like Materials, Industrials, Commodities and Banks.
The result is a highly confusing picture, much less consistent that most of the data we were blessed with over the past year. I believe this is a manifestation of a landslide asset rotation that is still in progress. The more this asset rotation progresses the greater the risks for stocks. So far they are not overly overweighted, but we’re getting there.
The fundamental question to ask when observing this survey is this: What must Mr. Market do with a 12 month horizon to inflict maximum pain on these investors? The answer is probably still in a robust economy with accelerating earnings and without significant rate cuts. But it will also come with limited upside. Cash is so underweighted that it must do well.
Correlation of bonds vs. stocks
In normal economic times, bond and stock returns don’t correlate much because rates correlate with economic growth which cancels out in an equity present valuation calculation. Statistically significant negative correlation typically happens during deflationary market crashes with an asset rotation from stocks to bonds (2008, 2015 or 2020).
Statistically positive correlation is extremely rare. It suggests that interest rate risk dominates other risk factors. Sell-offs happen due to rate scares and pumps happens due to rate reliefs. We have seen exactly that over the past 1-2 years. TLT’s beta against the S&P is now at an incredible level of 1. Long duration bonds are considered as risky as the average stock in the S&P. It sounds crazy, but it does make sense if you think about it. Every major correction in recent history was a rate scare, especially Oct’22 and Oct’23. And most of the positive periods came with rate relief.
This won’t be the case forever. With declining deficits, the next scares will not be rate scares, but growth scares which will come with falling yields. That will revive the value of bonds as equity hedges. Perhaps that alone will be a rate reducing force. Rate risk will decline and the market paradigm will shift from the right to the left chart in the illustration below.
Remember when I wrote about ‘never short the most telegraphed risk’ and argued that the next sell-off will typically not be driven by the risk factor that everyone is alert about?
Since inflation and associated central bank hawkishness have been at the centerstage for about 3 years, there is probably not much mispriced risk in this risk factor left. Therefore, inflation will either reaccelerate less than most people fear or - if it does - asset prices won’t be negatively impacted. Given the recent bond market puke, I believe the likelihood of the former significantly exceeds the likelihood of the latter. It would also help cash to perform adequately which it has to given its underweight.
Sincerely,
Your Fallacy Alarm