iShares 20+ Yr Treasury Bond ETF: If the Fed blinks, bonds will soar


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The consensus right now seems to be that there is no point in holding bonds because the Fed has just started its hike cycle and inflation is well above yields. However, bonds have a habit of perform well when you least expect it, and there are a number of factors that suggest this is a contrarian buy. First, recent weakness has seen real yields move back into positive territory at the long end of the curve when measured using long-term inflation expectations. Second, inflation expectations seem to be ignoring the current high CPI readings as commodity prices have stopped rising. Third, US equities continue to face downward pressure, and any further weakness could cause the Fed to start scaling back its rate hike plans. The iShares 20+ Year Treasury Bond ETF (NASDAQ: TLT) should perform well over the next few months, while offering the added benefit of protecting against a possible recession.


TLT ETF (Bloomberg)


TLT holds US Treasuries with maturities of 20 years or longer, with a weighted average maturity of approximately 26 years, an effective duration of 18 years and a current yield to maturity of 3.2%. The high duration means the ETF tends to show strong gains during times of economic weakness and/or disinflation, but losses can easily wipe out years of coupon payments during bear markets and are therefore a relatively risky fixed income instrument. The expense ratio is reasonable at 0.15%.

Real returns are now positive

Considering the current TLT yield of 3.2% relative to the current CPI rate, bonds seem like a bad bet here, with an actual yield of around -5%. However, long-term bond yields react much more closely to long-term inflation expectations – the average rate of inflation expected over many years based on the spread between regular and inflation-linked US Treasuries. Since the lows of March 2020, 20-year break-even inflation expectations have risen by around 200 basis points, to their current level of 2.6%, meaning that real 20-year bond yields are now firmly positive. As the chart below shows, 20-year bond yields are 61 basis points above long-term inflation expectations after rising 125 basis points in just 6 months.


UST 20-Year Yield vs. Inflation Expectations (Bloomberg)

Signs of inflation cooling

A few years ago, I was hitting hard on the risks of a spike in inflation (see here, here, here and here). However, after a significant rise in real bond yields, some stability in commodity prices, a rising US dollar, a narrowing fiscal deficit and an increase in credit stress, inflation expectations are coming under pressure. down in the short term.


Equilibrium Inflation Expectations (Bloomberg)

Break-even points across the curve appear to have peaked from a short-term perspective, and we’ll likely see headline CPI follow suit over the next few months. The annualized inflation rate based on April’s monthly printout was below 4%, and we should start to see year-over-year numbers converge towards that level over the next few months. While this would remain elevated relative to bond yields, it would ease pressure on the Fed to maintain its hawkish stance.

Weakness in stocks could trigger panic at the Fed

While the current priorities of the Fed focus on controlling inflation, the situation on the equity and credit markets looks increasingly precarious. Significant stock market declines and massive widening of corporate credit spreads have almost always caused the Fed to cut rates as its focus shifts to promoting financial stability. No one expects the Fed to reverse course, but that was also the case in 2000 and 2007, when financial markets and economic weakness caused major policy reversals. If equities continue their decline and headline inflation numbers start to fall, we could easily see the Fed start trying to scale back future rate hikes. With rates markets now pricing in hikes of nearly 200 basis points by year end, there is a lot of optimism about current bond yields, and any negative shocks would likely drive yields down significantly.


SPX versus 10-year UST (Bloomberg)

Insurance against a recession

I argued last month in “US Investors Should Switch From Stocks to Bonds Now,” unlike stocks, bonds offer the added benefit of performing well in adverse economic and financial conditions. Bonds have a proven track record of outperforming during periods of economic weakness, which is when positive returns become increasingly important. As shown below, of the last 8 recessions identified by the NBER, only one – the 1973-75 recession – occurred alongside the rise in UST 10-year yields. The others all saw their returns drop significantly, with an average drop of around 1%. If yields were to fall 1% from current levels, TLT would see a gain of around 25%.


UST and NBER defined 10-year recessions (Bloomberg)


As investors continue to steer clear of bonds due to inflation fears and Fed hikes, TLT looks like an increasingly good buy from a contrarian perspective. At 3.2%, its yield is well above long-term inflation expectations and there is strong potential for capital appreciation should the Fed reverse policy.


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