Bi-Weekly Asset Allocation – An Update on Bonds
October 17, 2022
Our starting point for examining bond yields begins with our yield model. The key elements are federal funds, the 15-year average of CPI (which is a proxy for inflation expectations), the rolling five-year standard deviation of CPI (a measure of inflation volatility), German Bund yields, oil prices, the yen/dollar exchange rate and the budget balance brought back to GDP. Based on this model, the current yield on the 10-year T-note is well below fair value.
Although yields have increased, as shown by the deviation line, they are still well below the model estimate. Interestingly, it is not uncommon for the spread to be lower than the model estimate as the economy approaches recession. This condition reflects the flattening and inversion of the yield curve. With monetary policy tightening, markets are beginning to expect slower economic growth which, in turn, is depressing long-term returns. However, the current gap is wider than normal, suggesting that a backup in yields is still likely. A return of 4.10% would be within the lower range of the standard error.
Long-term Treasury yields could be on track for consistently higher returns going forward. Since peaking in the early 1980s, the 10-year T-note has been falling steadily. Persistently weak inflation supported this downtrend. However, the market action suggests we may be at the turning point in yields, which if true, could create a secular bear market for bonds.
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Since the late 1980s, the downtrend has been consistent and mostly captured by a trend line flanked by
by a plus/minus one standard error of a regression model. This downtrend was definitely broken in March.
Why is the trend changing? Probably because investors fear that the inflation regime that
favored the downtrend is coming to an end. Rising political tensions, the collapse of the globalization regime and uncertainty about the will of policy makers to keep inflation low all combine to affect inflation expectations. Yield would be expected to decline during a recession. If the trend has really changed, the low will probably be above the upper line. If this happens, a long period of steadily increasing yields becomes more likely.
Past performance is not indicative of future results. The information provided in this report is for educational and illustrative purposes only and should not be construed as individualized investment advice or a recommendation. The investment or strategy discussed may not be suitable for all investors. Investors should make their own decisions based on their specific investment objectives and financial situation. The opinions expressed are current as of the date indicated and are subject to change.
This report was prepared by Confluence Investment Management SARL and reflects the current opinion of the authors. It is based on sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change. This is not a solicitation or an offer to buy or sell securities.