Bonds Poised to Outshine Equities by Wide Margin if Recession Hits
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I received many emails and questions on we are adding the U.S. Treasury bond to our portfolios. The question is understandable, given its dire performance in 2022, where bonds had the biggest drawdown since 1786.
Treasury Bond Annual Returns
However, there is, as they say,
A previous survey from BNY Mellon shows that very few people understand the bond market and how it works.
Bond Survey
Such is not surprising since the financial media focuses only on the side of the business – equities.
However, bonds are necessary from the investment perspective and the economic view. As we have discussed previously, low-interest rates are a function of an overly indebted economy. If rates rise too much, bad things have historically happened.
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Why Rates Cant Rise Much
Of course, as noted, interest rates reflect economic growth. As economic growth slows and disinflationary pressures present themselves, rates will ultimately track economic growth lower.
A Long History of Rates & Economic Growth
The chart below shows a VERY long view of interest rates in the U.S. since 1854.
The Long View Of Interest Rates Fed Funds GDP and Inflation
As noted, interest rates are a function of the general economic growth and inflation trend. More robust growth and inflation rates allow higher borrowing costs to be charged within the economy. Such is whyTo wit:
Therefore, it was unsurprising that the recent inflation surge preceded higher interest rates. However, that inflation push was artificial from massive monetary interventions. As monetary inputs fade, disinflation will push yields lower.
Inflation vs M2 YoY Pct Change
Disinflation from the contraction of liquidity will coincide with slower economic growth and, as noted above, lower interest rates.
M2 Annual Pct Change vs 10-Year Rates
Buy Bonds For Capital Appreciation & Protection
Understanding the dynamics between inflation, economic, and interest rates is a critical backdrop to understanding why now is likely the opportunity to increase bond exposure in portfolios for both income and capital appreciation. Most people view bonds as an income-only investment. With yields low, why own bonds? However, there is another aspect to bonds; capital appreciation.
There is an inverse relationship between bond prices and interest rates. When interest rates are low and rising, bond prices fall. However, when they are high and falling, bond prices rise.
Bond Price vs Interest Rates
In our portfolio management process, we buy bonds for three reasons:
If you consider bonds as an ” the analysis changes from an income strategy to a capital appreciation opportunity.
Using a monthly chart, treasury bonds are at a critical oversold juncture. Historically, when bonds were this oversold, such coincided with a financial event or recession. Such is not surprising given, as noted above, the impact of higher rates on a highly leveraged economy.
10-Year Treasury Bonds Vs Market
Since interest rates are the inverse of bond prices, we can look at this long-term chart of rates to determine when Treasury bonds are overbought or oversold.
Historically, bonds are the beneficiary of a rotation during market downturns. Such not only provides a return but reduces overall portfolio volatility.
Conclusion
The hope is that the Fed will again start dropping interest rates. However, as we have noted previously, the only reason for the Fed to cut rates would be to offset the risk of an economic recession or a financially related event. Should such occur, the rotation would cause a drop in rates toward the pandemic-era lows. Such a decline would imply an increase in bond prices of approximately 50%.
TLT Weekly Chart
In other words, the most hated asset class of 2022 may outperform stocks by a large margin if a recession occurs.
So, yes, we are opportunistically buying bonds for our portfolio.
