Torsten AsmusAfter years of unprecedented monetary and fiscal policies, we were finally reminded in 2022 that risk still exists and cannot be artificially taken away by the Federal Reserve. Risky assets were among the hardest hit areas of the market, with credit spreads expanding and momentum equities falling back down to earth. Inflation returned with a vengeance after many economists failed to anticipate what was plain to see all the way back in 2020. Deflationary environment will most likely slowly morph into inflationary. Source: Seeking Alpha More importantly, failing to anticipate recent developments also led to disappointing results for the most popular 60/40 portfolio and its derivatives as both equities and bonds moved in unison during the past year. Therefore, should the post COVID-19 economy experience less globalization and more inflationary pressures, it would seem highly likely that the two asset classes will move together going forward. Source: Seeking Alpha As painful as 2022 was, investors should now look ahead, instead of once again looking in the rear-view mirror. The latter appears to be the case for many market commentators regarding the iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT) and bonds more broadly. Down below I show why I disagree with bearish views towards TLT and what I believe is in store for the rest of 2023 and early 2024. How Did TLT Perform In 2022? As I said above, last year was an odd one with both equities and bonds falling, while inflation also accelerated to record highs. As a result TLT fared far worse than the S&P 500 and thus had a devastating effect to anyone relying on bonds to perform well during sell-offs in equities. Data by YChartsIf we go back 20 years, 2022’s one-directional performance of both fixed income and equities is indeed unprecedented. For most of the time, bonds have been an important counterweight for equity portfolios and thus significantly reduced risk. prepared by the author, using data from Seeking AlphaExtreme monetary intervention is largely to blame for the high correlation between bonds and equities we observed during 2022. The large influx of liquidity that also reached consumers through the helicopter money distributed in recent years brought a violent spike in inflation rates. Moreover, it also propelled most equities to highly unsustainable levels, thus distorting returns and bringing us to the mean reversion we observed during the past 12-month period. Although geopolitical tensions and deglobalization contributed to the lesser extent in the recent spike of the Consumer Price Index (CPI), these forces will continue to put pressure on prices over the long-term. That is why, investors should not rule out a second peak in the CPI over the coming decade. Over the short-term, however, the recent monetary tightening is likely to bring inflation down. During the last months of 2022, we already saw the annual change in CPI falling from its recent peaks. FRED It seems that the restrictive monetary policy is already paying off, with the annual change in money supply now close to turning negative (see the graph below). FREDWhere Is TLT Headed In 2023? When comparing the annual change in CPI and leading 12-month change in M2 we saw above, we could see why the current inflation is now expected to cool-off significantly over the course of 2023. prepared by the author, using data from FREDWith that, the pressure for the Federal Reserve to hit pause on its tightening efforts will also increase as a recession is looming on the horizon and elections are fast approaching. Needless to say, such a development will be highly supportive for bonds, while equities will be at risk of an economic slowdown. At present, the odds of a severe recession during the second half of 2023 or early 2024 are very high as the yield curve inversion reached levels last seen in the 1980s. FRED The annual change in the Leading Economic Index (LEI) is also foreshadowing a significant economic slowdown (see below). conference-board.orgThe last three times over the past decade when the LEI fell into negative territory or was close to doing so, either the monetary or the fiscal policy turned highly supportive. While the high inflation rates were preventing monetary and fiscal authorities from doing so this time around, a short-term decline in CPI will force them to act once again. FREDIf yields get too high, it could also spell disaster for the U.S. government as refinancing of government debt becomes prohibitively expensive. We should also not forget that we are now heading into a recession with the budget deficit at exceptionally high levels as a share of GDP. FRED Lastly, we could also use the gold to copper ratio as an indicator of where bond yields should reside. The denominator of this ratio (the price of copper) is indicative of the anticipated economic activity, while the price of gold is inversely related to real interest rates (at least in the short run). That is why when the gold to copper ratio rises, it is reasonable to expect a slowdown of economic activity and lower yields. Having said that, the gold to copper ratio indicates that 10-year yields should currently be at around 2%. prepared by the author, using data from FRED Bottom Line Everything said above, indicates that bonds yields are likely to come down during the course of this year, unless there is a major exogenous shock to the economy which propels the inflation rate to new highs. Given the risk of an economic slowdown, it also makes the current proposition for bonds far more attractive than that for most equities out there. Although this makes a compelling case for bonds more broadly, we should also take into account that the TLT is focused on the very long-end of the yield curve (20+ years). Long-term bonds’ higher duration makes the TLT more sensitive to changes in the overall level of interest rates, however, the short-end of the curve will likely be subject to more downward pressure in yields. Having said that, exposure to lower duration bonds is also desirable for investors looking to minimize risk.
