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posted on 01 June 2017

Is A Secular Bear Market In Bonds Possible?

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During the 35 year secular bull market that began in October 1981, there were a number of sharp increases in yields in which bond prices fell. But investors who held on were bailed out by the secular bull market and eventually recovered all the losses and with gains to show for their patience.

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In a secular bear market, patience is rewarded with more losses, as yields trend higher after any dip. This painful lesson was learned by bond holders during the 35 year secular bear market of 1946-1981. Just as bond investors could not imagine how the yield on the 10-year Treasury bond would decline from 15.68% in 1981 to 1.32% in July 2016, it is just as difficult to anticipate what events and economic conditions could cause yields to rise materially from current levels.

The coming government funding crisis is likely to play a role. The key point is respecting that secular bear markets occur and investors must be prepared to alter their investment strategy in order to deal with a bear market in bonds. The buy and hold approach which has served investors and financial advisors well since 1981 may be the wrong strategy, if the bond market is on the cusp of the next secular bear market.

On April 10, 1912 everyone boarding the Titanic knew they were getting on the largest passenger ship ever built. Before Mr. and Mrs. Albert Caldwell boarded, a Titanic crewman told them “Not even God could sink this ship." What the Caldwell’s, the crewman, and everyone else aboard the Titanic didn’t know was that at 11:40 p.m. on April 14 the Titanic would hit an iceberg and sink at 2:20 a.m., less than 3 hours after striking the iceberg.

Today, most Americans don’t realize that the U.S. economy is sailing toward a financial iceberg of excessive debt and unfunded government promises and programs. The Titanic was commandeered by a capable Captain. The two political parties commandeering the future of the United States have squandered the last two decades ducking their responsibility of educating and warning the American people of the coming government funding crisis so it could minimized. The coming collision between demographics and projected spending in Social Security, Medicare, Medicaid, and every other government program has the potential to cause an upheaval in the social, political, and economic foundations of this country.

Although the outcome is not preordained, time is running short. In 2016 the Trustees for the Medicare and Social Security programs estimated that Medicare’s trust fund will exhaust its reserves in 2028, and Social Security will follow in 2034. Medicare covers 55 million Americans, while 49 million are receiving Social Security benefits, and both programs will cover more people as Baby Boomers age. The increasing cost of both programs is driven by the aging of the U.S. population, so increasing economic growth can’t provide a total solution. Medicare and Social Security accounted for 41% of federal spending in 2016, up from 36% in 2011. The demographic headwinds facing the Social Security program underscore the problem. In 2008, there were 3.2 workers for each Social Security beneficiary. In 2016, the ratio of worker to beneficiary fell to 2.8, and is expected to fall to 2.2 during the next 20 years. If Congress does nothing before 2034, a 21% reduction in benefits will be necessary to stabilize the Social Security trust fund.

The longer Congress waits to act, the more draconian the ‘solutions’ will need to be and potentially divisive. The policy actions needed are likely to prove a drag on economic growth and require some amount of sacrifice for a large number of Americans. This is why addressing government entitlement spending is considered the third rail of politics. The sad reality is that both political parties are more interested in holding onto power, than doing what’s best for the country.

A combination of benefit cuts, tax increases, means testing of benefits received, and a later retirement age will be needed to sustain Social Security and Medicare. Younger generations will be asked to sacrifice their standard of living so older generations can receive most of the government benefits promised. It is easy to see why the magnitude of the coming changes has the potential to cause an upheaval in the social, political, and economic foundations of this country.

Risks for the Financial Markets

It is not possible to know whether the coming government funding crisis will merely be an extended period of disequilibrium or a major dislocation. What is fairly certain is that financial markets will be buffeted as this country wrestles with the social, political, and economic challenges the government funding crisis represents. This period of turmoil will present equity and bond investors with a high level of uncertainty, stress, volatility, and the risk of large losses.

Bonds

Financial advisors and investors who had a traditional allocation of 60% stocks and 40% bonds during the bear markets of 2000-2002 and 2007-2009 were partially insulated from equity losses that exceeded 50% in each bear market. Treasury bonds provided gains to offset losses, while investment grade corporate bonds performed well, especially in the 2000-2002 bear market. Even High Yield and Junk bonds helped cushion the equity losses, although they did lose money.

Given this recent history financial advisors and investors are likely to expect Treasury bonds to perform similarly in the next bear market. There are two reasons why financial advisors might not rely on this outcome. Interest rates peaked in 1981 and trended lower in a 35 year secular bull market. During this long bull market, each high in Treasury rates was below the prior high and each low was below a prior low.

What makes this 35 year time frame interesting is that the 35 year secular bull market from 1981 was preceded by a 35 year secular bear market that began in April 1946. During this secular bear market, the yield on the 10- year Treasury bond rose from 2.19% to 15.68% in October 1981.

welsh.2017.bonds.jun.01.fig.02

It’s possible that the low in the 10-year Treasury yield at 1.32% in July 2016 may have marked the end of the secular bull market and the beginning of a new bear market in Treasury bonds. Even if this proves to be true, the initial increase in Treasury rates is likely to be gradual. Pension funds and global investors are likely to buy Treasury bonds as yields tick higher. Buying is likely to emerge if the yield on the 10-year Treasury bond reaches 3.0%, 3.5%, and 4.0%, as these round levels will appear to offer value relative to the historically low yields in recent years.

The second reason is that the negative correlation between Treasury bonds and stocks is a relatively new phenomenon. During the 1940’s, 1950’s, 1960’s, 1970’s, 1980’s, and 1990’s, bond and stock prices were fairly correlated. Although stocks typically ignored the initial increase in Treasury yields, they eventually succumbed and a bear market followed. As the charts below illustrate, Treasury yields moved in response to changes in the Federal funds rate.

Click for large image.

When the Federal funds rate rose above the yield on the 10-year Treasury bond, a yield curve inversion was created, indicating a tight monetary policy. A yield curve inversion led to bear market declines in 1966, 1969-1970, 1973-1974, and 1981-1982. Interest rates declined once the Federal Reserve eased monetary policy, which launched a new equity bull market.

Click for large image.

After the secular peak in interest rates in 1981, yield curve inversions have been infrequent. An increase in interest rates preceded bear markets in 1983-1984, the stock market crash in 1987, and a shallow decline in 1994.

The 2000-2002 bear market was preceded by a yield curve inversion, after the Federal Reserve increased the Federal funds rate from 4.5% to 6.5%.

The financial crisis in 2008 was also preceded by a yield curve inversion, as the Federal Reserve increased the Federal funds rate from a historic low of 1.0% in June 2004 to 5.25% in July 2006. This inversion was unique in that the yield on the 10-year Treasury bond only rose from 4.7% in June 2004 to 5.2% in June 2007, despite the 4.25% increase in the Federal funds rate. Fed Chairman Alan Greenspan referred to this as a ‘conundrum’.

Click for large image.

In coming years, the Federal Reserve will be more constrained in how much they will be able to increase the Federal funds rate given the high level of debt. The ratio of total debt to GDP has soared from $1.65 for each dollar of GDP in 1982 to $3.55 of debt for each dollar of GDP in 2016.

Rising interest expenses from higher interest rates will prove a burden on over indebted consumers, companies, and the federal government.

It will take a smaller increase in rates to slow the economy in coming years than in the past.

This suggests the coming bond bear market will not be as devastating as the 1946-1981 bear market. The economy will simply not tolerate the yield on the 10-year Treasury bond rising to 8.0%, let alone the 1981 peak of 15.68%.

In reviewing the chart of the 10-year Treasury bond, an increase to near the 2007 high of 5.20% seems plausible within the next decade. Although yields are not likely to rise as much as in the prior bear market, losses could still be significant as the table below illustrates.

welsh.2017.bonds.jun.01.fig.06

When the yield of the 10-year Treasury bond rose from 1.40% in July 2016 to 2.40% in December 2016, the price of the bond declined by - 8.84%. Should the yield rise to 3.4%, it will decline by another 7.99%, bringing the total decline to -16.83%. And if the yield climbs to 5.20%, the total loss would increase to over -28.0%. Treasury bonds with maturities longer than 10 years would experience even larger losses. This discussion is meant as a reference with actual results dependent on numerous factors.

During the 35 year secular bull market from 1981, there were a number of sharp increases in yields in which bond prices fell. But investors who held on were bailed out by the bull market and eventually recovered all the losses and had gains to show for their patience. In a secular bear market, patience is rewarded with more losses, as yields trend higher after any dip. This painful lesson was learned by bond holders during the secular bear market of 1946-1981. Just as bond investors could not imagine how the yield on the 10-year Treasury bond would decline from 15.68% in 1981 to 1.32% in July 2016, it is just as difficult to anticipate what events and economic conditions could cause yields to rise materially from current levels. The coming government funding crisis is likely to play a role. The key point is respecting that bear markets occur and investors must be prepared to alter their investment strategy in order to deal with a bear market in bonds. The buy and hold approach which has served investors and financial advisors well since 1981 may be the wrong strategy, if the bond market is on the cusp of the next secular bear market. This suggests that investors and financial advisors should consider adopting a tactical approach for a portion of their bond assets. A tactical strategy could minimize losses during periods when yields are rising, and potentially add capital gains when bond yields fall.

In March 0f 2017, I thought the yield on the 10-year Treasury bond could fall from 2.60% to under 2.20%, as the economy displayed signs of slowing and a record short position held by institutional investors expecting higher interest rates in the Treasury bond futures were forced to cover. The 10-year Treasury yield fell to 2.177% before rising to 2.42%. The pattern in the 10-year Treasury yield bond suggests the yield could fall below 2.177% and approach 2.0%. However, the coming low in the yield could represent a higher low relative to the July 2016 low of 1.32%, and set the stage for the next move up in yields before the end of 2017. This suggests a review of the allocation to bonds and the investment strategy employed in managing bond market risk by investors and financial advisors is appropriate.

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