The Long-Term Bond Market Bull

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1 McVite Equity Group Newsletter 1 st Quarter Singapore, January 30, 2018 The Long-Term Bond Market Bull Bulls believe the bond trend is still up, but evidence suggests otherwise. Rising confidence and improving economy will hurt bond prices in Contrarian sentiment also suggests that bonds have further to fall. Bond investors have endured a tough start to 2018 as Treasury prices across all maturities have plunged in the last four weeks. Instead of capitulation, however, many bond investors are stubbornly clinging to the belief that the bull market in Treasury bonds, which prevailed for much of the last decade, lives on. Some have even expressed a belief that bond prices will rebound this year and surprise the skeptics. The weight of evidence suggests otherwise. McVite Equity Group fixed income analysts make the case here that investors should prepare for higher interest rates in the months and years ahead.

2 One of the strongest examples that the long-term bond bull market is over is the significant increase in confidence by both consumers and business owners. Indeed, confidence in the economy s prospects can be considered an obstacle to higher bond prices. For instance, according to the NFIB, 2017 was the most remarkable year in the 45-year history of the federation s well-known Small Business Optimism Index. The Optimism Index for December month came in at 104.9, slightly lower than the near-record November report but still a historically exceptional performance. This makes 2017 the strongest year in the history of the survey, according to the NFIB, beating the previous record set in The surge in small business optimism is another sign in a growing list of indications that the economy is poised for take-off in That s potentially bad news for bond bulls since rising confidence typically leads to bond liquidations as investors switch their focus from capital preservation to a growth-oriented strategy. Meanwhile consumer confidence also continues to rise impressively from its 2011 low. According to the University of Michigan Consumer Sentiment index, confidence among consumers is at its highest since before the last recession began in 2007.

3 With money demand declining as confidence increases, safe-haven bond purchases are giving way to risk taking. This in turn increases the potential for a return of inflation in the coming years. Currently there are just over $2 trillion in excess bank reserves, which means there is a super-abundant money supply. Eventually, rising confidence will result in deployment of this money which will in turn result in higher prices for almost everything. Interest rates will rise accordingly. To argue that the long-term bond market bull still lives is to insist that the economy will remain weak or stagnant instead of growing year-by-year as it has for some time now. The bond bull argument carries with it the underlying assumption that investors will demand safety above profits. In other words, it argues that investors will value return of capital instead of return on capital. Belief in the bond bull s continuance requires that we ignore the enormous amount of QE created in the wake of the credit crisis. That money growth hasn t yet been fully unleashed, but it s inevitable that as producers and investors gain greater confidence in the strength of the economy, money velocity will increase. And with an increase in money velocity comes inflation and higher interest rates. PQ = MV

4 As the U.S. economy continues to expand, it s inevitable that interest rates will rise and bond prices will decline. A revival of the long-term bond bull market would almost require a recession or a severe financial market setback, neither of which are likely in the foreseeable future. As the Small Business Optimism Index chart suggests, business owners are planning for an economic expansion, not contraction. Turning our attention to the current outlook for Treasuries, the downward trend which was established in late 2017 continues to hold sway over bond prices. The sharp decline in short-term government bonds, along with the decline in short-term corporate bond prices, will continue to exact a toll on 20+ Year Treasury Bonds. Longer-term bond prices had stubbornly resisted the selling pressure which plagued short-dated Treasuries, yet eventually Long Term Treasures succumbed to the downward pull exerted by shorterterm bonds. One of our favorite leading indicators for the 20+ Year Treasury Bond ETF (TLT) is the Vanguard Short-Term Corporate Bond ETF (VCSH), shown below. There is a wellestablished correlation between the trend of short-term corporate bonds and Treasury bond prices, with the former often leading the latter. It s normally not a good idea to purchase government bonds when short-term corporate bond prices are slumping, which they have been doing for the last four-and-a-half months.

5 Consider also the progression of the ishares 3-7 Year Treasury Bond ETF (IEI). The 3-7 year Treasury ETF price has been in decline since early September, well before the 20+ Year ETF (TLT) began showing signs of weakness in December. IEI is another leading indicator for the TLT, and when both IEI and VCSH are in declining in unison it s usually only a matter of time before longer-term Treasury bond prices start sinking. This time should prove to be no exception. Presently the downward trend in Treasury prices is still underway as confirmed by the two graphs shown above. While a technical bounce is possible in the days ahead, the commencement of a new upward trend in T-bond prices is unlikely based on the current investor sentiment profile. According to data provided by Consensus Inc. the bullish consensus on T-bonds among investment advisories is still remarkably high by historical standards (above 50%), especially considering how relatively weak bonds have been in recent weeks. This suggests the bond market decline has a ways to go before bottoming out.

6 Rising optimism over the economic prospects for 2018 will put downward pressure on bond prices as the conditions which created a demand for Treasuries in past years continue to fade. As the U.S. economy further strengthens and gradually returns to its long-term growth rate, investors will be inclined to seek attractive returns in areas other than sovereign debt. Those expecting a revival of the long-term bond bull market will accordingly be disappointed. They should instead turn their attention to the equity market, which will benefit far more than Treasuries from the prevailing climate of rising confidence and economic expansion. Contact Us on how you might trade the long end of the debt market or hedge your bond portfolio risk. info@mcviteequity.group