A recent bet by Bill Ackman, which effectively bets against long-duration Treasuries, has garnered attention from the investment community. It seems counterintuitive that when all the signs point to a recession in the USA, one may assume that betting against Treasuries would be a losing trade; maybe not.
Historically, when equities do not do well, your high quality bond portfolio acted as a “hedge” that gave you diversification and lower volatility, with the added effect that during recessionary periods, the Fed would decrease interest rates and your long-duration trade on (let’s say Treasuries) would appreciate due to the inverse relationship between the price of a bond and its newly issued interest rate against the old bonds you were holding before the interest rate cut. Historically, this “flight to quality” trade to US Treasuries has been something investors have used to either increase returns or protect capital.
Here is the basic cyclical algorithm that the 60/40 portfolio (and many investors) relied on for the past 40-ish years:
Recession → equities down → Fed drops interest rates / buys assets → bonds up → GDP recovers → equities up → Fed tightens to fight excess inflation/credit → recession → REPEAT.
For a macro-environment with benign inflation, a 60/40 portfolio could have worked well on a risk-adjusted basis.
However, THIS TIME IS DIFFERENT.
Foreign holders of Treasuries are increasingly net sellers of US sovereign debt, and the US GDP seems to be dominated by the fiscal spending by the US government (and increasingly so), not the private sector.
Recession makes the deficit increase as tax revenues decrease due to asset price deflation and overall decrease in taxable activity from the private sector. This means that the government has to finance its spending with even MORE debt, not less. On top of that, the Fed is still implementing its sell-off of bonds via “quantitative tightening.”
In the case for Treasuries, given the following:
1) the Fed will not likely decrease rates anytime soon to preserve its credibility,
2) energy and housing inflation will likely be sticky in the short-term, due to lack of new supply from higher financing costs from higher interest rates,
3) AND the US federal government will likely issue MORE (not less) bonds to finance its spending,
… interest rates on US Treasuries are likely to increase. Economics 101: too much supply relative to demand equals lower prices.
In the near future, the Fed (even though it may not decrease rates nominally) will have do something to backstop the Treasury market and do “QE” again. Until then, the bond market “doom loop” seems to be accelerating and the 60/40 portfolio looks riskier in the short-term.
The two key factors to watch are
(1) the US Dollar strength and
(2) energy inflation.
If they continue to increase, the bear market in US bonds will likely continue.