Making the Case for TLT

Being a contrarian for contrarian’s sake is a bad way to invest. However, going against the herd can be more profitable than not with a disciplined approach. This leads me to recommend a long-term investment in TLT for long only investors.

In this post, I’ll make the case for TLT by:

  • Analyzing previous and current drivers
  • Positioning and outlook
  • Considering the current consensus arguments

As the global economy continues to slow, the risk/reward scenario for TLT outperforming the S&P 500 is skewed to the reward side for investors with a multi-year investment horizon. There are obviously risks associated with TLT, as there are with any investment, but the pros outweigh the cons in my opinion.

Just a reminder, these are only my thoughts and please do your own research before making any investment.

Analyzing Previous and Current Drivers

When analyzing the various treasury yields, those with the longest maturity dates are the most sensitive to growth. The 30yr Treasury Bond is currently the longest bond issued by the US Treasury, thus the most sensitive. Prior to 1977, the 10yr Treasury Bond had the longest maturity.

Since the longest maturity bonds are the most sensitive to growth, the nominal yield of the long bond tends to be highly correlated to US Nominal GDP. (note: nominal = inflation + growth)

10yr Treasury Yield (yellow), US Nominal GDP (white), NBER Recession Indicator (red)
Source: Bloomberg

From 1960 until 1981, US Nominal GDP and the 10yr Yield were trending higher together. In the late 1970s, inflation was over 10%, which helped push yields higher despite US Nominal GDP falling.

Since bond yields peaked in 1982, the US economy began to mature as the US population aged, which has gradually decreased the overall demand of finished goods and helped push inflation down to the levels we have today. One item of note is that the increase in inflation we saw from 2004 to 2008 was largely contributed to the rise of China as they were building their massive infrastructure projects.

Source: St Louis Federal Reserve

Historically, the ISM Manufacturing Survey was the best way to measure global growth. From 1986 until 2000, when ISM peaked the 30yr Treasury Yield tended to peak with it.

ISM Manufacturing (white), 30yr Treasury Yield (yellow)
Source: Bloomberg

However, things began to change in the 2000s with the rise of China. Instead of the 30Yr Yield being solely correlated to ISM, it began to transition to global manufacturing. While the 30Yr did peak in 2004 with ISM, it remained elevated due to the inflation associated with China until global manufacturing peaked in 2007.

30Yr Treasury Yield (yellow), ISM (white), Japan’s Tankan (purple), Europe’s ESI (green)
Source: Bloomberg

Moving to our current period, global manufacturing slowed with ISM in 2011 but 2014 showed the disconnect once more. A larger separation has been seen over the past year as ISM increased to over 60 but the 30Yr Yield remained subdued.

ISM Manufacturing (white), 30yr Treasury Yield (yellow)
Source: Bloomberg

As discussed in previous posts, China is the growth driver of the world. While the 30Yr Treasury Bond is issued by the US, it can be argued that the main driver has become China. This becomes more apparent when China’s major trading partners began to see their exports slow in early 2011, early 2014, and throughout 2017, the 30Yr Yield tended to decline as demand from China slowed.

Australia (blue), Brazil (green), South Korea (red), US 30Yr Yield (black)
Source: Bloomberg

Comparing this to China’s 5Yr yield, it continued to increase as the PBOC pushed rates higher despite demand slowing.

Australia (blue), Brazil (green), South Korea (red), China 5Yr Yield (black)
Source: Bloomberg

However, we do know from recent history that the US 30Yr Yield and China’s 5Yr Yield tend to decline together as growth slows.

In the current situation, China is a little ahead in the recent decline. However, the PBOC pushed it to a level much higher than it should have been, just like they did in 2011 and 2013 in hopes of displaying a strong economy.

US 30Yr Yield (yellow), China 5Yr Yield (white)
Source: Bloomberg

Turning the focus to the US, we now have all three major segments of consumer discretionary spending beginning to show signs of slowing. This is the first time this has occurred in this business cycle.

Auto sales have been negative on a year over year (Y/Y) basis for a number of months. Based on the 1 and 3 month average, it looks like this could soon drag the more stable 6 month average lower.

US Auto Sales Y/Y: 6 month average (blue), 3 month average (green), monthly data point (red)
Source: Bloomberg

The Mortgage Bankers Association (MBA) Purchase Index began to decline a few months ago. While the contribution to GDP from housing has declined from the previous cycle, the multiplier effect still makes it a very important part of the US economy.

MBA Purchase Index Y/Y: 26 week average (blue), 12 week average (green), 8 week average (yellow)
Source: Bloomberg

Lastly, Retail Sales saw a noticeable tick down this month after stalling around 4.5%. It’s too earlier to say this is definitely slowing but it’s worth noting as auto and home sales are slowing.

Retail Sales excluding Autos and Gasoline Y/Y: 6 month average (blue), 3 month average (green), monthly data point (red)
Source: Bloomberg

As mentioned in a previous post, the savings rate for the US consumer is near record lows, which does not bode well for an increase in demand of finished goods.

Source: St Louis Federal Reserve

Finally, the growth rate of balances on credit card is potentially peaking at a level lower than a year ago. Again, this would imply less future demand relative to the past. This is why I mentioned Retail Sales potentially slowing because customers tend to use their credit cards when making these types of purchases.

Source: St Louis Federal Reserve

Putting this together, the two largest drivers of global growth are in the process of slowing. I still believe that China will begin to stimulate their economy and lead global growth higher later in 2018. However, they have yet to do so, thus delaying the potential rebound in growth.

Positioning and Outlook

When looking at the Commitment of Traders report, investors are positioned for the 30Yr Yield to increase despite growth beginning to slow globally. As the narrative changes from increased global growth, investors will need to reverse their positions like they did going into 2014. (note: when bond prices increase, yields decline and vis versa)

30Yr Bond Net Positioning
Source: freecotdata.com, @movement_cap

When considering the possible return an investor could make on the TLT, I prefer to look at it on a total return basis, which means the price appreciation plus reinvesting the dividends as they are received.

In the following chart I have the month that ISM peaked and troughed along with the total return of TLT and the S&P 500 during that time frame. With ISM over 60 for only the third time in the past 30 years, the risk/reward is tilted in favor of the investor that is willing to hold their investments for a number of years, thus delaying the expense of paying taxes by trading frequently.

A historical period where TLT performed poorly relative to the S&P 500 after ISM peaked was from June 2004 to June 2007. In this scenario, the US slowed while global growth and inflation accelerated due to China’s massive infrastructure projects. However, those that continued to hold TLT were rewarded as yields declined during the financial crisis, as seen by the bottom line in the chart above.

Considering my current outlook of growth reaccelerating in the second half of 2018, but not to the levels seen during 2017, the holding period for this investment would be approximately 30 months (i.e. 2020) with an estimated total return of 40-50%. While a 15% annualized return is nothing to get too excited, relative to how the S&P would do during a recession, it would be a great investment for a long-term investor.

By the way, if the US economy gets to 2020 before falling into a recession, it would be the longest economic cycle in history as it eclipses the previous record of 120 months from 1991-2001. Currently, the US is in its 104th month of economic expansion.

Considering the Current Consensus Arguments

There are three consensus arguments against investing in TLT:

  • The US deficit is rising and makes our debt less attractive
  • The Treasury Department is issuing more debt as Central Banks are reducing their purchases of debt (i.e. increased supply)
  • Additional tariffs and/or a trade war with China will increase prices and therefore inflation and yields

1st Argument – The US deficit is rising and makes our debt less attractive

While I am sympathetic to this argument, the debt issued by the US government is still the most sought after during periods of slowing global growth and especially during a recession.

The best example of this is during the US Financial Crisis. Despite everything going on with the US economy, our deficit increasing significantly, and the US Treasury department drastically increasing the debt outstanding, the yield of the 10Yr and 30Yr bond continued to decline as investors increased their purchases.

If the deficit continues to increase on an absolute level and relative to other countries, I would not want to own TLT during a typical economy growth cycle like we just went through the past two years.

Source: St Louis Federal Reserve

Source: St Louis Federal Reserve

2nd Argument – The Treasury Department is issuing more debt as Central Banks are reducing their purchases of debt (i.e. increased supply)

According to Bloomberg (https://www.bloomberg.com/news/articles/2018-03-12/bond-enforcers-reawakening-as-deficits-and-inflation-risks-build ), the amount of debt the US Treasury Department will issue is set to average $1.27 Trillion over the next five years after averaging half of that amount the previous five years.

This has been openly discussed by the Treasury Department after they were advised to issue predominantly shorter-term debt in November (https://www.bloomberg.com/news/articles/2018-01-23/welcome-to-the-new-reality-of-leaping-u-s-treasury-debt-sales ).

At the same time, the Federal Reserve has announced that it will begin to shrink its balance sheet that consist of Treasury Bonds and Mortgage Backed Securities (https://www.bloomberg.com/news/articles/2017-10-13/long-awaited-fed-balance-sheet-taper-begins-today-with-mortgages ).

Finally, the ECB is looking to reduce the number of bonds it purchases as well. (https://www.bloomberg.com/news/articles/2018-03-08/ecb-is-said-to-assume-final-qe-push-totaling-30-billion-euros )

Combine this together and it sounds like a potential disaster for the bond market. It also helps explain the positioning of investors and why yields have been rising in the Developed Markets the past few months. Keep in mind that this was also occurring during a time of economic growth.

As the market becomes more concerned about slowing global growth, investors should quickly soak up the additional supply in the market driving yields lower, especially those bonds that are the most sensitive to growth like the 30Yr.

Finally, as the market continues to decrease the difference in 30Yr Yield and 2Yr Yield, the market seems to be more concerned about shorter term rates rising due to the large increase in supply and the US Federal Reserve raising interest rates than it is about longer term rates and the much smaller increase in supply relative to shorter term maturities.

30Yr Yield – 2yr Yield (white)
Source: Bloomberg

3rd Argument – Additional tariffs and/or a trade war with China will increase prices and therefore inflation and yields

Additional tariffs and/or a trade war with China are my biggest concerns regarding TLT. The US economy can handle a small number of items that have increased prices due to tariffs (i.e. Canadian lumber tariff – https://www.bloomberg.com/news/articles/2018-01-03/u-s-trims-duties-on-canadian-lumber-in-lingering-softwood-spat ). The same could be said regarding the tariffs announced last week dealing with steel and aluminum (https://www.bloomberg.com/news/articles/2018-03-04/lessons-from-2002-show-economic-bang-from-steel-tariffs-was-tiny ).

However, if Trump goes through with the tariffs on Chinese produced goods (https://www.reuters.com/article/us-usa-trump-china/trump-eyes-tariffs-on-up-to-60-billion-chinese-goods-tech-telecoms-apparel-targeted-idUSKCN1GP2X8 ), then we should expect China to deliver a strong response. This tit-for-tat would result in higher price tags for numerous products, which the US economy would not be able to absorb as easily.

While the increased prices would be transitory, the immediate and short-term effect would be higher inflation, thus higher bond yields. The size and scope of the price increase would determine the increase in inflation and the decline in demand for finished goods (i.e. slower growth). While this would initially be a poor environment to be invested in TLT, relative to the S&P 500, TLT would outperform.

One thing to keep in mind with Trump is that his bark tends to be worse than his bite. For example, when the steel and aluminum tariffs were first announced, the tariffs were going to be placed on every country, allies and enemies. A few days later during the signing ceremony, this changed to having numerous carve outs for allies that were willing to sit down and discuss the issues at hand. By the way, nations don’t like forced negotiations.

My thought is that he will once again have numerous carve outs once he realizes the number of products that are designed in the US by US companies but manufactured in China. The iPhone would be an example of this and is probably why Tim Cook (Apple CEO) was in D.C. this week having dinner with Ivanka Trump and Jared Kushner. I believe that this is what the market expects as well, which should result in a muted effect for bond yields when announced.

However, if we have an escalating trade war then I would expect yields to spike initially before eventually declining as global growth slows. A well-known reference for this is 1930 with the Smoot-Hawley Tariff Act, which resulted in yields initially spiking around the time of passage before declining as growth slowed.

Source: Bank of America, Merrill Lynch

Source: Bank of America, Merrill Lynch

Summary

While the arguments against TLT are compelling, my overall view of the global economy slowing swings the case to recommending an investment in TLT for those investors with a multi-year investment horizon on an absolute return basis and relative to the S&P 500.

Update on Stress in the Market

Two weeks ago I described how I analyze stress in the market (https://wp.me/p9vaFZ-3z). Based upon previous periods, Friday, March 2nd was not the end of the market stress we have witnessed over the past month. In this post I’ll make the case for my analysis by:

  • Analyzing characteristics in recent times of stress (2015 and 2016)
  • Comparing the previous periods to what occurred on Friday, March 2nd
  • Current outlook and expectation

The move in the VIX spread continues to tell me that we have not transitioned from the turbulent times of the past month. Also, the recent lack of improvement in the spreads leads me to believe we have more risk ahead of us.

Analyzing Recent Times of Stress (2015 and 2016)

When comparing previous moves in the spread during times of stress, March 2nd was not the bottom for the market.

When looking at what occurred from August – September 2015, the move on Monday, September 28th was a large move to the downside (i.e. a move with conviction). A move like this is typically associated with margin calls (i.e. forced sellers), which leads to a “flush” of the market to the downside and then a fast recovery higher.

S&P 500 (yellow), VIX Contract X 15 – VIX Contract V 15 (white)
Source: Bloomberg

A similar type of move can be seen in February 2016. In this time period we had a change in the front month contract, which complicates historical analysis. Also, by not having intraday data on the chart, it doesn’t show that at the worst point of February 15th, the market was down ~2.5% from the close on February 14th.

S&P 500 (yellow), VIX Contract G 16 – VIX Contract F 16 (white), VIX Contract H 16 – VIX Contract G 16 (white)
Source: Bloomberg

When there is a change in the contracts, as with 2016, it truly shows how important it is to analyze the individual contracts during times of increased stress instead of relying on continuous, or generic, contracts.

S&P 500 (yellow), Generic 2nd Month Contract (UX2) – Generic 1st Month Contract (UX1) (white)
Source: Bloomberg

Comparing the Previous Periods to What Occurred on Friday, March 2nd

When I compare 2015 and 2016 to what occurred on Friday, March 2nd, I see an orderly move lower in the spreads compared to the “flush” in the previous periods.

The first chart shows the 2nd month minus the 1st month ending on March 2nd. The move that began five days earlier descended in a linear fashion, which is not indicative of a “flush” or forced selling.

S&P 500 (yellow), VIX Contract J8 – VIX Contract H8 (white)
Source: Bloomberg

The same decline can be seen on the next chart showing the 3rd contract minus the 2nd contract.

S&P 500 (yellow), VIX Contract K8 – VIX Contract J8 (white)
Source: Bloomberg

To summarize, the lack of the “flush” last Friday has me believe that we have yet to see the bottom in the spreads, and the market, for the near term.

Current Outlook and Expectation

When looking at the charts of the spreads, we are once again seeing them stagnant, which is a concern. The concern is heightened because we have peaked at a lower high while still in backwardation.

S&P 500 (yellow), VIX Contract J8 – VIX Contract H8 (white)
Source: Bloomberg

S&P 500 (yellow), VIX Contract K8 – VIX Contract J8 (white)
Source: Bloomberg

As shown in the February post “Update on Macro and Markets” (https://wp.me/p9vaFZ-2T), we know volatility tends to first pick up when there is a change in market leadership (i.e. cyclical to defensive). Knowing this, I continue to closely watch the Euro and Oil.

It seemed that during the first bout of volatility, market participants began to question their positions since they are no longer making new highs.

EUR/USD (white), Oil (yellow)
Source: Bloomberg

However, positioning has only declined slightly. Therefore, these are still very crowded trades.

EUR/USD Commitment of Traders (COT)
Source: freecotdata.com (@movement_cap)

WTI Commitment of Traders (COT)
Source: freecotdata.com (@movement_cap)

In order for the market to complete the change in leadership from cyclical to defensive, the positioning in these trades will need to change.

Whether it occurs in the next bout of market stress or the one after that, I can’t be sure. However, with global manufacturing declining for the second consecutive month, it seems that we are getting closer to this occurring.

Source: Markit, JPM