Cliff Asness - "Bonds are Frickin' Expensive"
As a boring economist, I will not use his colorful language, but the current fixed income world is not normal and bonds have gotten all the more abnormal over the last three months. Treasury 10-year bonds have seen their yields cut in half in a little over 6 months. Long bond rates are touching all time lows since the Financial Crisis even though we are not in a recession. Bond futures prices have skyrocketed with an increase of 20 points since March. The rally has been driven by outside capital buying higher US yields, a flight to safety for some investors, and speculative expectations of further Fed cuts. It does not matter who is driving the buying. Bonds are reflecting extreme expectations.
These extreme expectations are not just from strong short-term buying. Beyond price technicals, there are a number of fundamentals that point to expensive bonds. The term premium or excess yield necessary to hold longer-term debt has turned negative as measured by the NY Fed. These negative premia have been negative for over a year, and continue to trend lower. The yield curve has inverted based not just Fed tightness but on strong buying pressure at long durations that have pushed yields lower faster than the front-end of the curve. The yield on bonds are less than the cost of financing in the repo market, so the only reason to hold is based on expectations of further yield declines.
Inflation, albeit low, when subtracted from nominal rates suggests negative real returns. Real rates may go negative when there is a surprise shock to inflation or a central bank pushed rates lower, but these negative real rates is based on strong bond buying not inflation surprises. Looking at the relationship between the yield slope, real yields and industrial production, Cliff Asness argues for bonds being expensive. Industrial production does not justify the bond rally.
Unfortunately, we are not in a normal world nor is it likely to become normal in the near future. Investors have to accept continued irrationality and be bond buyers or assume the world will move to rationality, avoid bonds, and potentially miss what could be a great fixed income opportunity. We have seen this story before in Japan and Europe. Investors do not believe a bond rally can continue and only further rate declines. Investors are forced to make choices that would have thought unacceptable in earlier times.
These extreme expectations are not just from strong short-term buying. Beyond price technicals, there are a number of fundamentals that point to expensive bonds. The term premium or excess yield necessary to hold longer-term debt has turned negative as measured by the NY Fed. These negative premia have been negative for over a year, and continue to trend lower. The yield curve has inverted based not just Fed tightness but on strong buying pressure at long durations that have pushed yields lower faster than the front-end of the curve. The yield on bonds are less than the cost of financing in the repo market, so the only reason to hold is based on expectations of further yield declines.
Inflation, albeit low, when subtracted from nominal rates suggests negative real returns. Real rates may go negative when there is a surprise shock to inflation or a central bank pushed rates lower, but these negative real rates is based on strong bond buying not inflation surprises. Looking at the relationship between the yield slope, real yields and industrial production, Cliff Asness argues for bonds being expensive. Industrial production does not justify the bond rally.
Unfortunately, we are not in a normal world nor is it likely to become normal in the near future. Investors have to accept continued irrationality and be bond buyers or assume the world will move to rationality, avoid bonds, and potentially miss what could be a great fixed income opportunity. We have seen this story before in Japan and Europe. Investors do not believe a bond rally can continue and only further rate declines. Investors are forced to make choices that would have thought unacceptable in earlier times.
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