Bonds Breaking Bad

October 7, 2022

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Government Insolvency is now in play.
Long Term Government Bonds are becoming uninvestable.

We have thus succumbed to a blind faith in bureaucratic authority over natural processes.” Mark Spitznagel, The Dao of Capital: Austrian Investing in a Distorted World

Difficulty is what wakes up the genius
― Nassim Nicholas Taleb, Antifragile: Things That Gain from Disorder

While the economic focus is typically on growth and inflation there are new factors in play. Financial stability has come to the fore after the recent dramatic policy reversal at the Bank Of England, and in the background, what no one wants to talk about is debt.

The chart below shows that not only does the UK bond market face astonishing new demands through refinancing suddenly at around 3% to 4% higher interest rates, as an initial estimate, but in addition, the economy will have to finance three times the normal amount of new bonds. This is new math, and let’s hope so, because in my old math it does not add up!

The US numbers are no better

Sovereign Man explains:

Here’s a startling example: on October 27, 2020, the Treasury department issued around $50 billion worth of 2-year Treasury Notes at a yield of just 0.12%. Well, now it’s two years later, and those 2-year Treasury Notes are about to mature. So the government is going to have to issue a new $50 billion batch of bonds to pay off the maturing debt.

The problem is that interest rates have risen a LOT since 2020. The 2-year Treasury yield is now 4.2%, and rising. In other words, the new $50 billion issuance will cost the government an additional $2 billion per year in interest ($50 billion x 4%).

Now imagine this problem for the ENTIRE $31 trillion national debt.

Rates are already, on average, around 3-4% higher than they were a few years ago. And if the average interest rate on the national debt increases by just 3%, that means the government will owe an EXTRA $1 trillion per year, just in INTEREST.

In case you’re wondering, total interest in the Fiscal Year that just ended last Friday is an unbelievable $706 BILLION. If rates keep rising, annual interest payments could increase to nearly $2 trillion.

You’d think that the Treasury Department would be doing everything it can to extend their average bond maturity, and increase it from five years to, say, ten years. That would at least make a dent in the problem.

Or that Congress and the White House would get their fiscal house in order and start balancing the budget.

But no. Not these people. In fact the Treasury Secretary has specifically stated that she does not want to extend maturities.

This is a real crisis brewing. And the people in charge are deliberately ignoring it.”

If you thought the UK and the US math was problematic then you haven’t looked at Hollands 17% inflation rate

With Euro interest rates around zero this must be a new record for negative real interest rates. Any idea what the 10 year bond yield should be?

Inflation may not fall quickly if OPEC has a support level for oil

The news out of OPEC this week was that they cut production quotas by 2 million barrels a day, clearly against President Biden’s request. This comes at a time when crude oil stocks are low and the US Strategic Petroleum Reserve has been depleted to a 40 year low.

Oil has rallied around 11% off the recent low which may boost near term CPI readings, and this OPEC decision does make the oil price very well supported particularly if there is a cold winter or any pick up in world growth.

For the time being this should weaken growth through both higher prices and, if anything increasing the likelihood of increased interest rates for longer.

Growth has continued to weaken

No surpise in housing. With mortgage rates almost 7% the cost of buying a house has exploded.

So purchase applications have collapsed to 10 year lows.

The US ISM manufacture index fell to just over 50 the recessionary level.

Policy confusion

With growth so weak politicians are incentivized to “stimulate” their economies with new debt financed spending. This happened recently in the US and now also in the UK. Not only does the debt predicament not seem to be a matter of concern but these packages seem in contradiction with central bank tightening policy.

Once again this makes the central bank inflation challenge that much greater, and furthermore makes clear that overall planning of economic policy is incoherent and negligent as regards many fundamental key issues. The confidence needed to overcome the uncertainies over the future decades of a long term Treasury bond are unsurprisingly suddenly absent.

Investment allocation

Bonds with maturity over 5 years have now become a gamble. Short of any discussion, let alone a plan, on debt management long term bonds appear to be out of control, and the explosive increase in volatility of bonds is appropriate as investors wake up to new uncertainty about pricing and the challenging long term outlook. Inflation risks remain and the new increased scale of financing has become a major issue at these higher interest rate levels.

The only attractive area in bonds is the TIPS market with maturities less than 5 years given the uniquely attractive real yields now around 1.5%. Unusually high for a weak economy.

Equities remain highly valued and earnings growth is declining and may go negative. Outside of special cases the allocation should remain low.

Commodities are in a downtrend in a declining growth environment, however they will offer great opportunity though when the cycles turn.

Gold is the most attractive allocation in a stagflationary environment, but is unlikely to perform well until the dollar and/or interest rates reverse current trends.

The dollar will likely remain strong as US interest rates continue to rise in a declining growth environment.

The main caveat is timing as the trend in 2-year Treasury yields remains higher. This means a defensive allocation remains appropriate until this trend reverses. Furthermore, with volatility very high across all asset classes this is the market’s signal to avoid assets until volatility begins to decline to lower levels on a more permanent basis.

Strategy Summary

With growth still weak and declining, and bond yields still trending higher my allocation is broadly unchanged since this was discussed in August. Government FRNs and cash remain the major allocation with options positions the main focus for performance.

In the current environment passive long positions become a very challenging strategy and substantial losses are likely with drawdowns that may take years to recover. Best Investor standards and techniques avoid these conditions and drawdowns and offer consistent performance over the whole investment cycle through all conditions.

To find out more, schedule a FREE consultation today. Let me use my expertise and multi-decade experience to apply Best Investor risk management methods in this current environment to navigate your portfolio for the uncertain and potentially challenging conditions ahead.

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