I decided to go long - duration that is. I've decided to exit most of my safe SGOV positions yielding 5.3% and pivoted into some TLT, ZROZ, and mostly individually purchased extreme duration/convexity treasuries like CUSIP: 912810SN9. Overall I moved over $200k from the overnight duration to >25 years.
I was a bit late, but I was waiting for a signal and better late than never. For example, TLT hit bottom on 10/19 and rallied +4.8% as of today, outrunning the S&P500. Other long-duration bonds of course followed suit. In hindsight, I should have been picking up duration while I was suggesting such bonds in the "Most Intriguing Investment" thread. My recommendation timing was perfect. However, I didn't immediately execute because I lacked confidence in the themes I've been developing in this thread and elsewhere, reluctant to fully grab the falling knife until there was some sign of a reversal. So I only sold a few TLT puts, which quickly swung OTM. Since 10/19, 30-year rates have collapsed from 5.11% to 4.82%. It might be a short-term zig zag, but at this point I think the risks of being early are balanced by the risk of missing the trend.
My big shift from no-duration to extreme-duration is based on the following premises:
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1) Long-term yields are historically high compared to inflation expectations. This chart shows the difference between 30y nominal treasury yields and the 30y inflation breakeven rate derived from TIPS vs. nominal yields. Thus, the market itself expects +2.47% real returns from 30y treasuries, an unusually high point comparable to what markets expected after the GFC. Another interpretation might be that the TIPS market is underestimating inflation, but I don't think so because of reasons described below.
2) Inflation excluding shelter is at 1.99%. Thus we do not have a money supply problem, broad inflation expectations problem, or a velocity of money problem. We have a problem that can be narrowed down to the price of shelter, and this component alone is propping up CPI, Core CPI, PCE, and Core PCE. This observation is consistent with the explanation that we're simply going through a housing bubble, not that general "inflation is too high" as JPow keeps stating. If the Fed is mistaking an asset bubble for a broad loss of purchasing power by a currency, then they've hiked rates far into positive real territory and that will soon suppress the economy. One could argue the high rates will be necessary to pop the bubble, but (a) targeted policy interventions would have been preferable to sacrificing the entire economy, and (b) the performance of the broader economy is what might force a rapid series of rate cuts in the next 2-3 years, so if the Fed sacrificed the economy to pop the bubble, that's the reality - not what should have been. As that scenario comes into view, we should plan for it.
3) Rate Hikes Are Probably Over. According to the
Fedwatch tool the odds of a December hike have fallen from 39.45% a month ago to 4.5% today. Now the Fedwatch tool is showing a probable rate cut by May. I agree with the market's current assessment, but it's not because of the herd. It's because 8% mortgage rates and high borrowing costs across the board must be getting close to breaking something. I cannot tell exactly where the fracture will occur - residential, CRE, regional banks, shadow banks, derivatives, big banks, overnight markets, various overseas markets - but never have rates risen this far this fast and not resulted in something snapping. Even if all we get is an unemployment rate slowly grinding upward, that still reverses the course of interest rates.
4) Experts Are Calling The Top In Interest Rates. Bill Ackman made a fortune shorting treasuries earlier this year, but something spooked him
out of the short position in October. Pimco's Bill Gross called for a
recession starting this quarter, citing a sudden increase in delinquencies. Jamie Dimon recently
said JP Morgan is "trimming the sails", i.e. said he's reducing JP Morgan's real estate exposure, due to vacancies, and taking $114 million of his wealth out of the company's stock. According to
other media reports, Jeffrey Gundlach is positioning for rate cuts. Gundlach said:
“I think either rates will stay high for longer, which is not my base case but I acknowledge that’s a possibility, but if the economy rolls over as I expect, the Fed is not going to cut rates 50 basis points, they’re going to cut rates 200 basis points,” he explained. “That’s what’s wrong with the cash strategy.”
I don't normally give much credit to billionaire pundits, as their incentives are not aligned with telling reporters what they truly think or what their real indicators of interest are. Yet there's a certain alignment here: something bad is going to happen.
5) Yield Curve Un-Inversion Suggests Recession Is Near. The beginning of yield curve inversions typically signal that a recession is on the way within the next 2-3 years, and that gets talked about a lot. Less talked about is the un-inversion of a previously inverted yield curve, which signals we're either in a recession or mere months away from one. Times in the past when
10y/2y yield curve un-inversion signaled fun times ahead included April 2007, December 2000, & October 1989. The yield curves inverted in the middle of the early 1980s recessions. As we've seen since April 2022, a lot can happen in the stock market in the months/years between inversion and recession. However, I suspect un-inversion is the clearer signal that a bearish trend will occur or continue in stocks, and interest rates are about to fall as everyone flees to safety. As shown by the 2nd set of charts of the 10y/2y and 10y/3m inversions, we're more than halfway back to zero - potentially only a few months.
6) Rapid Economic Growth Doesn't Mean Recession Isn't Around The Corner. Recessions start when economic growth reverses and goes negative, so by definition there is always growth before a recession starts. Therefore we cannot point to economic growth in a past quarter and say that performance predicts there won't be a recession in the near future. Not even when
GDP comes in at a blistering 4.9% annualized rate like it did in 3Q2023. Here are some
GDP growth rates for calendar years prior to the year when a recession started:
2019: +2.2%
2006: +2.9%
2000: +4.1%
1989: +3.7%
Similarly, today's low
unemployment does not predict continued low unemployment. If anything, 3.9% unemployment means the economy cannot continue to grow due to a physical limitation - a lack of workers! Companies can poach workers from each other, but every time they gain a worker another company loses a worker. This behavior comes at no net gain to the overall economy. And we all know what the consequence of not growing is: It's shrinking. Unemployment arguably has nowhere to go but up, though it can stay depressed like this for years. After hitting the all-time low of 3.4%, unemployment is now up to 3.9% due to a rise in
labor force participation. If the following chart wasn't labeled, one might mistake it for a very interesting and reliable recession indicator.
7) Transports are suffering. I'm not big into Dow Theory and I don't watch ^DJT but I am paying attention to
recent bankruptcies and layoffs in the trucking and logistics industries, amid talk of a
freight recession. Meanwhile shipper Maersk just
announced a layoff of 10,000 employees(!), saying their revenues have halved. If supply and demand are growing, then why aren't transportation companies?
8) Another Debt Standoff Could Occur. If treasury issuance was interrupted again this year, it would be the icing on the cake because it would drive demand into the remaining issues, pushing up prices and pushing yields down. Another shutdown would also greatly increase the odds of a recession.
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The FFR futures market anticipates a 100bp lower FFR by December 2024. I think we'll be 200bp lower by December 2025. I also think the distortions of unaffordable housing prices at very high mortgage rates, very high expected real rates available from treasuries, continued tight policy amid no widespread inflation problem other than housing, and a decade of investment in low-yielding activities will eventually resolve via defaults, unemployment, falling interest rates, business consolidation, and real estate fire sales.
Of course I might be wrong in a few ways:
- The past 2 weeks could be a head fake and the yield curve could continue un-inverting via a rise in the long-term side. I'll know the pain if that is the outcome!
- We might have entered a multi-year "higher for longer" regime JPow keeps guiding toward, and which the long-term bond market was seemingly coming to terms with just weeks ago. If we don't have a recession, this scenario could happen. The good news is one can hold 25+ year treasuries for a long time waiting for one's thesis to come true. It's not time-bound like an option play. From that perspective, and looking at the historical odds of recessions even in years not preceeded by 525bp of rate hikes, it's a very safe play. Also, my bonds will experience small capital gains due to the passage of time alone, because that brings the big cash flow at the end closer and reduces its discount. Confirm this feature using a bond price calculator.
- The Fed could keep hiking the FFR and lifting the entire yield curve until the bitter end, sacrificing the economy to ensure the housing bubble is dead. Jamie Dimon has been talking about the possibility of FFR rate hikes to 6.5%. However even this painful scenario eventually ends with massive 1980s style rate cuts. Long-term bond investors will eventually sense the overreach and lower expectations appropriately.
- Inflation could take back off again, especially if oil prices spike, or Chinese exports are interrupted. That could prop up long-term rates and lead to all of the above. However I doubt this because for every sector of the economy that isn't housing, 3.5% real rates and QT are taking a toll.
