The Case for Bonds Now

Buying bonds in the aggregate now can be a smart idea. Inflation may remain high for quite some time but it appears to be peaking. Leading economic indicators in July will support a 75 BP rate hike from the Fed and the bond market will look ahead to a softening economy, which will, in turn, support higher bond prices.

Bond Prices and Interest Rates

Bond prices generally move in the opposite direction of interest rates. Thus, rising rates place downward pressure on bond prices. The longer the duration, the greater the sensitivity, which means that long-term bonds will generally fall further in price than short-term bonds when rates are rising.

As a general rule, a 1% change in interest rates will cause a bond’s price to change about 1% in the opposite direction. For example, a bond ETF with an average duration of 20 is expected to fall in price by about 20% for every 1% increase in interest rates.

Is It ‘Fighting the Fed’ to Buy Bonds Now?

If bond prices move in the opposite direction as interest rates, why would an investor buy bonds now? Isn’t that “fighting the Fed?” Investors thinking this way need to remember that economists look backward, and capital markets look forward. Thus, for a contrarian investor, it’s tactically a smart move to start buying bonds before the end of a tightening cycle.

Put simply, interest rates don’t have to fall before bond prices go up. This same idea is applied when contrarian investors buy stocks as the Fed officially calls a recession. By the time the Fed figures out it’s a recession, it’s getting closer to the end of that cycle, thereby a good time to buy stocks.

Economic Indicators Pointing Toward Higher Bond Prices

The June 2022 CPI reading was extremely high at 9.1%, but this reflects June’s inflation numbers. The July reading will show that gas is falling, supply bottlenecks are loosening, and the housing market is slowing.

These numbers will justify the Fed staying on the 75 BP rate hike as previously forecast, not 100 BP, as many investors began to expect after the June CPI reading.

• Gas falling: The average price for one gallon of regular gas is $4.495, down from its June 14 peak of $5.01.
• Supply issues improving: Manufacturers’ delivery times are shortening in some Fed regions. The June Manufacturing PMI was 53%, down 3.1 percentage points from the reading of 56.1% in May, and the lowest PMI reading since June 2020.
• Housing: Inventories are rising, as well as interest rates.
• Yield curve inversion: The 10-2 Treasury yield spread returned to negative in July. Since WWII, every recession has been preceded by an inverted yield curve. The inversion tends to precede the recession by 6 to 18 months.
• GDP: Real gross domestic product decreased at an annual rate of 1.6 percent in the first quarter of 2022, following an increase of 6.9 percent in the fourth quarter of 2021.

You’re Not ‘the Judge’

I think Keynes’ “beauty contest” observation is a smart way for investors to view capital markets. He suggested that investors are wise not to predict a winner based upon the face they think is the prettiest one, but rather the face that they believe the judges will believe is the prettiest.

The point here is to invest based upon what you think will happen, not what you believe should happen.

The bond market, or the investor herd, makes its moves based upon what it expects the Fed to do in the coming months. Thus, the judge is the Fed. And since the Fed is generally dovish, and economic indicators are pointing toward a slowing economy, they won’t raise rates as aggressively as many armchair observers believe is prudent. Smaller rate increases could follow later this year.

Bond History: What It’s Telling Us Now

As Mark Twain famously said, “History does not repeat itself but it does rhyme.” Following this wisdom, don’t try to find a period in history that’s an exact parallel to today’s economic environment because there isn’t one. Instead, it’s wise to look for a rhyme, and that rhyme says that bond price movement will be positive, and quite possibly above-average, in 2023.

To find the rhyme, I’ll reference a report showing historical returns on stocks, bonds, and bills, as well as inflation and other data, from 1928 through 2021.

Here are my key findings about bond market history:

• There are only two instances in history, 1955-1956 and 1958-1959, where the US Treasury Bond fell in price for two consecutive years. The following years, 1957 and 1960, the US T Bond jumped 6.80% and 11.64%, respectively.
• Investment grade corporate bonds have been negative for two consecutive years only twice since 1928. The first instance was 1956-1957 and the second time was 1979-1980. In the years immediately following these instances, 1958 and 1981, corporate bonds were up 6.43% and 8.46%, respectively.
• The closest “rhyme” to today’s inflationary environment was the 1979-1980 period, when inflation was 13.29% and 12.52%, respectively. What’s more remarkable is that inflation was still high in 1981 at 8.92%, and corporate bonds jumped 8.46%. In 1982, when inflation was a more reasonable 3.83%, bonds skyrocketed by 29.05%.

Key takeaway: Since 1928, bond prices have risen 100% of the time after a period of two consecutive years of negative returns. Both Treasury bonds and the aggregate bond index were negative in 2021. Even if there is a positive turn in the second half of 2022, this calendar year will remain negative, setting up a potentially historic jump in 2023.

Bond Prices Are Already Moving Higher

As of this writing, the early movers (myself included) are beginning to stick out their necks, so to speak, and pick up shares of bond ETFs. For evidence, look no further than the 1.54% gain for iShares Core U.S. Aggregate Bond ETF (AGG) over the past month. That’s a big move for a bond fund.

For further evidence, consider the price movement of what is arguably the most interest rate-sensitive bond fund on the market, the PIMCO 25+ Year Zero Coupon Bond ETF (ZROZ), which is up 4.33% over the past month.

Bottom Line

Bond prices generally move in the opposite direction of interest rates. But price moves occur according to the expectations of bond investors in the aggregate. Therefore, we don’t need to wait for falling rates to see higher bond prices. Going forward, bonds will rise on more news of a slowing economy and an increased risk of recession.

As a tactical asset allocator, I like to dollar-cost average into assets (stocks, bonds, commodities) that can outperform in the coming phase of the cycle. Since the coming phase is a slowing economy, bonds appear to have the best risk/reward balance over the next 6 to 18 months. Thus, a slow but steady shift toward bonds can be a good idea now.