The Treasury Rally Is Set To Continue - Here's Why
EPB Macro Research
Another week has gone by with another slew of research notes, TV pundits, and media talking heads declaring the Treasury rally to be overdone, exhausted and nearing a top.
I am amazed at why there is such a desire to call a top in bonds, or a bottom in interest rates, especially when the fundamentals don't support it.
For those that have been following the work we publish at EPB Macro Research, you know that we have been calling for lower interest rates since early 2018 and reinforced that call when the 10-year Treasury rate was making it's scary rise to 3.25% in October of 2018.
In fact, here is what I wrote back in October 2018:
"If you buy long-term bonds today, it will prove fruitful as we have not yet seen the secular low in interest rates.
I am still a buyer of the long bond."
Fast forward and we have seen a new secular low in the 30-year Treasury bond, which fell below 2.0% and currently sits at 1.99% as of this writing.
Since that call in October, long-term Treasury bonds have risen by more than 40% while the S&P 500 has dramatically lagged behind, increasing by only 7.1%.
Why have so many missed this call and continue to argue for a rise in yields? Firstly, many pundits misunderstand the dynamics between growth, inflation and bond yields.
The first issue is that many analysts are not focused on the "rate of change." The bond market is not concerned with anyone's personal assessment of inflation or growth or subjective descriptions such a "good", "solid" or "okay".
The bond market is concerned with factual descriptions of growth and inflation such as accelerating or decelerating.
The true beauty of this analysis is that there is no room for opinion. Nominal growth (growth + inflation) is either rising or falling. Where nominal growth is headed in the future is up for debate, but for that, we use objective baskets of long leading and short leading indicators that both logically lead in the economic sequence and have been proven to lead economic cycles throughout history.
Before looking at some leading indicators to asses where the economy is headed, let's take a look a coincident economic data point to understand the move in interest rates.
Nominal Final Sales of GDP, or Core GDP, which strips out inventory and net exports, has decelerated much more sharply than consensus is seemingly willing to admit, falling from 6.1% in Q2 2018 to 3.6% in Q2 2019.
A sharp decline in bond yields should not be a surprise in the context of a 40% reduction in core nominal growth.
To reiterate, 3.6% nominal growth may be "good" to some and "bad" to others but what this actually represents is a deceleration in the rate of growth.
Many characterize this move as a benign reversion to trend without considering the implications a rate of change slowdown in growth has across asset prices including cyclical equity sectors vs. defensive sectors and Treasury rates more specifically.
The decline in domestic bond yields is nearly entirely correlated to this deceleration in the rate of growth and inflation. Just as bond yields rose sharply from 2016-2018, when core nominal growth accelerated from 2.8% to 6.1%, when growth is in a trend of deceleration, bond yields follow.
To get the direction of bond yields correct, we need to understand if nominal growth (growth + inflation) will accelerate from 3.6% or decelerate from 3.6%.
For that, we use a combination/confirmation process of long leading and short leading economic indicators.
Any single data point will fail at various points throughout history. There is never one single perfect indicator. However, when you combine several data points that all have strong track records in forecasting turning points in growth and analyze the aggregate, false signals are dramatically reduced.
One data point may fail, but the average is significantly less likely to fail, especially when another layer of confirmation is added by using long leading data and short leading data.
Long leading economic data starts the economic sequence and can lead by 12-18 months on downturns and 6-8 months on upturns. Short leading data, as the name suggests, has a shorter lead time over economic cycles and can inflect 6-8 months before downturns and 2-4 months before upturns.
By using this process of long leading aggregate indicators, confirmed by short leading aggregate indicators, we can have a high degree of confidence in the next direction of economic growth and therefore, nail the move in interest rates as we have done the last 40%.
One of several long leading indexes we use, which saw the downturn in the global PMI with more than a 12-month lead time, is currently suggesting more downside to come.
This leading indicator, which is focused on various monetary aggregates, has a trough rate of growth in December 2019 before a small upturn in Q1 2020.
This indicator suggests the sharpest part of the slowdown may still be ahead.
If there were a sufficient upturn in several of our long leading indexes, we would then shift our attention to shorter leading indexes to pinpoint the inflection in nominal growth.
Even though there has not been a sufficient upturn in long leading data, let's have a look at a shorter leading index.
The next chart is a main EPB Macro Research short leading indicator which can be seen to have a reliable lead over cyclical turning points, outlined by the US ISM PMI.
When confirmation across long leading and short leading data matches, a high level of conviction can be had in a future turning point.
With long leading and short leading data showing no signs of a rebound through year-end, the highest probability forecast is that growth remains in a trend of deceleration over the next couple of months.
As we looked at earlier, if nominal growth moves lower (deceleration), we should expect bond yields to follow.
I would continue to expect lower bond yields based on the leading indicators of growth and the leading indicators of inflation (not covered here), which are also pointing lower.
The easiest way to use the leading indicator process is to be long of cyclical equities during up cycles and shift to overweight bonds and defensive equities during down cycles. It also makes logical sense and can be done in both tactical accounts and your more long-only passive accounts. Aggressive during up cycles and defensive during down cycles.
Knowing the economic cycle, which you will virtually all the time with a combination of long-leading and short-leading indicators, is the biggest tailwind to have at your back when making investment decisions.
Understanding the direction of the economic cycle is the best way to maximize your upside and minimize your downside risk. The biggest risk to your portfolio always happens when you are on the wrong side of the cycle.
Cycles last several quarters on average so once you identify the turning points, which the leading indicators will do, all you have to do is ride the cycle with the proper asset allocation.
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