5 Essential Facts For Today's Bond Investors

seekingalpha08-28

Bond investors have benefited from the recent market pullback, with bonds hedging the S&P's 9.7% pullback.Some bonds are up more than 8%, and the bond market will be pricing 2% of rate cuts next year....

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However, long bonds are overvalued without a recession, with a downside risk of up to 14%.Nine leading indicator models show that the economy is 94% likely not in recession, and GDP growth will slow from 2% to 1.3% before accelerating again.In recent weeks, the economy has started accelerating at an accelerating rate, which is very bullish for stocks and bearish for bonds. I use dynamic hedging ETFs (managed futures and yield futures) to go long or short bonds (and stocks, commodities, and currencies) when it makes sense. Currently, managed futures are short bonds, though that's changing quickly.   LumerBIt's been a wonderful market pullback for bond investors so far. YChartsWith interest rates resetting to historical levels, the growth scare triggered the 9.7% S&P pullback, hedged by bonds just as investors expect from these non-correlated asset classes. In fact, at the recent peak, Pimco's long-bond ETF (ZROZ), the longest-duration bond ETF on Wall Street, was up 8% while the S&P's peak closing low so far was -8.5%. Since this is the worst bond bear market since 1787, bond investors might be excited at the prospect that \"our ship is finally coming in.\" Daily Shot However, I wanted to warn readers and members that the recent bond rally is likely slightly overdone and is not supported by fundamentals. Bonds and stocks are very different asset classes. While stocks rally strongly off bear market lows for prolonged periods, bond math is more straightforward and very different. In other words, here are three things bond investors need to know to avoid painful mistakes in the coming months. Fact 1: The Bond Market Is Potentially Overshooting The Fed CME GroupThis is what's currently priced in the bond market. And here's the cumulative probabilities. CME GroupCurrently, the bond market is pricing in 1% worth of cuts this year. While 2% worth of cuts by July are reasonable (averaging one cut per meeting through July 2025), 1% of cuts this year are a crucial reason why bond yields currently look like they do. The bond market is not pricing in a recession because bond futures currently price in the long-term Fed fund rate of 3%. In a recession, the Fed doesn't cut to neutral; it cuts to 1% to 2% below neutral. CNBC10-year yields of 3.85% are the most important benchmark rate for the economy because this is what mortgage rates and corporate borrowing benchmark from. In other words, mortgage rates and corporate bond yields are a function of the risk-free 10-year yield + some risk premium (fluctuates with the economy). Many bond investors think the bond market pricing in 2% worth of cuts within a year is boom times for bonds.  2% fall in yields X 7 duration (bond average) = 14% gains in one year. 2% fall in yields X 26 duration (ZROZ) = 52% gains in one year.  Ritholtz Wealth Management Historically, after the Fed pauses rate hikes, bonds tend to do very well, with long bonds soaring by almost 30% in the next two years. However, that's because most recessions have historically been caused by the Fed overdoing it on rate hikes. In other words, bonds tend to do best following a Fed pause (June 2023) because the Fed over-tightens and triggers a recession, and bonds are the best-performing asset class in deflationary recessions. It's also important to remember that 10 and 30-year yields don't follow short-term yields lower as the Fed cuts.  The Fed controls short-term rates only. The bond market drives long-term yields based on economic and inflation expectations.  As the Fed cuts rates, cash yields will fall under long-term ones, uninverting the yield curve, which is supposed to be upward-sloping. If the growth scare fades, the long end of the curve is likely to stay relatively flat or even rise a bit. Fact 2: Bonds Have Limited Upside Unless We Get A Recession Ritholtz Wealth Management For decades, about 90% of bond returns have been explained by starting yields for bonds. Bloomberg, RBCThe same is true for US corporate bonds, with EU bonds more driven by economic expectations. FactSetThe blue-chip economist consensus expects 10-year yields to bottom around 4.03% (average) yield next year and remain stable around 4.14% long-term. The 30-year yield (ZROZ, EDV, and TLT) is expected to bottom around 4.25% and long-term average around 4.68%. In other words, according to the best proxy for the long-term fair value of bond yields, bonds are currently overvalued unless we experience a recession. In a recession, bonds become overvalued relative to long-term rates.  What You Need To Know About Protecting Your Portfolio From Recession And Bear Markets How to use trailing stops to maximize the realized gains of bond rallies in recessions.  Trailing stops are the most effective way (though no strategy will capture 100%) of excess bond returns in recessions.  This strategy works for all hedging assets. Which become overvalued in recessionary bear markets (or bear markets in general).  For example, 10-year yields are currently 3.84% compared to 4.14% in the long-term consensus. Yields might be 2% to 3% during a recession, but they will return to around 4% after the recession ends.  The Fed has officially said it never plans to go to negative rates. And prefers to never again go to zero unless necessary. Zero rates are a historical anomaly that will likely not be repeated.  Thus, bond investors celebrating substantial gains in recessions and bear markets must understand that the long-term pre-tax return for bonds is expected to be around 4%. Yield = long-term pre-tax returns for bonds. Fact 3: The Data Shows No Signs of Impending Recession Those are eight real-time indicators I now use to track the economy.  Atlanta Fed GDPNow New York Fed GDPNowcast St Louis Fed GDPNowcast Baseline and Rate of Change Economic Grid Silver Bulletin Economic Index St Louis Fed Financial Stress Index Kansas City Fed Financial Stress Index Chicago Fed National Financial Condition Index NDD's weekly real-time indicator report.  These nine economic models include more than 150 weekly updated metrics that examine every part of the US economy. If a recession is coming, we'll see it in this data. Atlanta Fed GDPNow: 2.0% Real-Time GDP Growth Atlanta FedNew York Fed GDPNowcast: 1.8% GDP Growth New York FedIn recent weeks, the New York Fed's real-time estimate has fallen significantly but merely to 1.8% trend growth. By definition, reversion to long-term means is never a cause for alarm. New York FedManufacturing and housing weakness is dragging the most on the economy, with retail sales still strong. Consumer spending is 70% of the economy, manufacturing is 11%. Should the negative trend continue, then that will merely match the current economist consensus. Bloomberg A slowdown to 1.5% GDP growth in the second half of the year is not only expected, but it's also what corporate profit growth estimates are priced off. OK, so the economy appears to be headed for a soft landing, but how can we know, in real time, whether the facts are shifting against us? St. Louis Fed GDPNowcast: 1.3% GDP Growth St. Louis Fed The St. Louis Fed's real-time economic model tends to be more conservative, using monthly rather than weekly data. It points to 1.3% growth, consistent with 1.5% GDP growth in Q3 and possibly Q4. How low should we expect GDP growth estimates to remain on track for 1.5% GDP growth in Q3? At what point should we become concerned? The next model answers that question. We turn to the Baseline and Rate of Change grid to do so. Baseline and Rate of Change Economic Grid David Rice maintains the BaR grid, which is updated weekly and tracks 19 economic and nine leading indicators. David Rice He plots each report as it comes in, compared to the 30-year baseline, and how quickly they rise or fall each month. David Rice The orange dot (weighted mean of coordinates) shows the economy's current state. The green dot (leading indicator) shows where the orange dot will be heading in the coming months. The leading indicators are below baseline but accelerating upward. The rate of acceleration has been rising in recent weeks. So, the economic weakness might have bottomed because the rate of change of the rate of change (third derivative) is positive at the moment. David Rice While the overall WMoC is down 2.5% over the last three months, parts of the economy, like small business optimism, are up significantly.   Ritholtz Wealth Management Small businesses employ 55% of Americans, and their optimism is at two-year highs. This is not what happens before a recession. In the last three months, we've also seen consumer confidence and industrial production improve. There has been an industrial recession for over a year, even as the overall GDP grew almost 3%. David Rice The WMoC is down almost 5% compared to a year ago, which is what the Fed was trying to do. The key to understanding how slow economic growth might reach in these real-time models is to use the current business cycle. David Rice Peak growth (6.9% GDP) occurred in Q4 of 2021, and the fastest rate of economic acceleration occurred in Q3 of 2020 (17% improvement MoM). Based on this, we can calibrate the following model.  Each 1% above or below baseline is 23.2 basis points of growth. 2.3% below baseline (leading indicators) = -0.5% peak slowdown. 1.8% trend growth -0.5% slowdown = 1.3% minimum growth rate (1.0% last week) This data points to a soft landing.  So, the economic outlook has improved modestly since last week, but a 0.3% higher minimum growth is a major difference to Main Street.  Each 0.1% of GDP is $25 billion in economic output. So, in the last week, the expected economic output for this year is up $75 billion.  Silver Bulletin Economic Index Nate Silver has the most advanced election forecasting model and uses real-time economic data and forecast data on election day to estimate how the election will play out. Nate Silver Nate Silver Nate Silver Nate Silver Nate Silver Nate Silver Nate Silver's model probability estimates are similar to other forecasting models. Economist The economist's real-time election forecasting model estimates that Vice President Harris will receive 276 electoral votes compared to Nate Silver's 279. Polymarket, the most significant betting market, also shows a tight race, though slightly favoring former President Trump. Polymarket Polymarket Polymarket Polymarket is helpful because it tracks the House and Senate, which matter far more to investors than those who win the White House. Polymarket represents hundreds of thousands of real-money bettors betting over $1 billion on the election. YChartsBesides the 40,000 daily simulated elections, this model's unique feature is the economic model, which Nate Silver says he's considering continuing post-election. Nate Silver Currently, the economy is 0.04 standard deviations above the two-year rolling average and is expected to improve modestly by election day. This is what the model was saying last week. Nate Silver The outlook for industrial and inflation has improved modestly for the next 75 days in the last week. St. Louis/Kansas City/Chicago Fed Financial Stress Index Zero is the average financial stress since inception (as far back as 1971). Right now, every index and sub-index, covering over 120 weekly financial metrics plugged into every part of the economy, is showing below-average financial stress. Since 1971, that has never happened with the US economy in a recession. YChartsThe financial markets estimate a 6% (1 in 17) that we're in a recession right now. Daily Shot NDD's weekly real-time indicator report. Weekly Indicators: Lower Interest Rates Continue To Provide A Boost Summary (from New Deal Democrat)  Weekly indicators provide an excellent nowcast of the economy and can predict changes before monthly or quarterly data is available. Data is presented in a factual format with minimal commentary to minimize bias. Long-leading indicators show improvements in mortgage rates and credit spreads. Short leading indicators remain generally positive, while strong consumer spending aids coincident measures.    The long-leading indicators remain “less negative” than they were until recently, as mortgage rates and the 2 vs. 10-year spread anticipate lower interest rates. Mortgage refinancing is also back in action after being comatose for several years. The remaining negative indicators are those most under the Fed's direct control. The short leading indicators are also mainly positive, and the coincident indicators continue to be buoyed by tame gas prices and firm consumer spending. Aside from the financial indicators closely tied to the Fed, the economic negatives are generally confined to manufacturing. Construction has been helping maintain growth. While the monthly residential construction report was poor (influenced by Beryl), mortgage applications showing renewed life are significantly positive.\" - NDD     NDD   NDD  NDD Cumulative Summary Positive: 13 Neutral: 12 Negative: 9 This confirms that the economy will unlikely be in a recession or headed for one anytime soon. If that changes, I'll see it in the data and warn you.   Fact 4: What This Means For Bond Investors I'm not saying that bonds should be sold right now, any more than I recommend trying to time the stock market using historical valuations. Whatever your optimal allocation to bonds is, you should stick to it. Your financial advisor will help you adjust your optimal asset allocation over time as your life situation specifics shift. However, I wanted to reset expectations from some jubilant bond investors, who think 2% of rate cuts in the next year will trigger 15% to 50% gains.  The Fed doesn't control long-term yields; the bond market does. A 2% decline in the Fed Funds rate will not translate into a significant decrease in long-term yields. Any short-term rally in long-term bonds at these yields is only justified by a recession. There's no indication that a recession is coming.  Remember that bonds are a low-volatility insurance policy that pays you to own it. That's how you need to think about owning bonds. Something that usually goes up in market downturns (as long as downturns aren't caused by rising inflation), that, unlike puts, pays you long-term income to own them. However, don't forget about taxes and inflation.          ETF Pre-Tax Annual Return Since Inception Post-Tax Return Tax Expense Ratio % Of Returns Eaten By Taxes   ZIVB 62.09% 54.89% 7.20% 12%   SVOL 12.14% 5.60% 6.54% 54%   JEPQ 16.87% 11.82% 5.05% 30%   JEPI 8.36% 4.29% 4.07% 49%   VNQ (REITS) 7.48% 5.63% 1.85% 25%   BAGPX (60-40) 6.02% 4.51% 1.51% 25%   AGG (Bonds) 3.07% 1.87% 1.20% 39%   SCHD 12.80% 11.72% 1.08% 8%   VYM 8.33% 7.41% 0.92% 11%   COWZ (FCF Yield, Deep Value) 13.53% 12.72% 0.81% 6%   SPY (S&P) 10.13% 9.48% 0.65% 6%   QQQ (Nasdaq) 9.74% 9.21% 0.53% 5%   Click to enlarge (Source: Morningstar)  Long-term bond consensus: 4.14% Inflation (30-year bond consensus): 2.28% Real long-term bond returns: 1.86% Taxes (39%): 1.61% Real-post-tax bond returns 0.25%  Bonds are expected to generate minimal long-term returns after inflation and taxes. That's by design. Risk-free insurance policies against market corrections should not be expected to create significant real returns. Fact 5: What This Means For Managed Futures/Yield Futures Investors I don't own any bonds because I own managed futures and yield futures as my preferred hedging strategy.       ZEUS Family Fund Portfolio Composition     Hedges 46.70%   Managed Futures 43.59%   Carry 3.10%   Stocks 60.13%   Fantastic Five 53.30%   S&P 6.83%   Value 22.36%   Growth 30.95%   Total 106.83%   Click to enlarge  CTA: 5 Reasons I Added This 7.6% Yielding ETF To My Portfolio KMLM: 5 Reasons You Might Want To Buy This 8.2% Yielding ETF  Here are my dives on my two favorite managed futures ETFs. Unlocking The \"Holy Grail\" Of Investing With Return Stacking ETFs Here is a deep-dive interview about return stacking and yield futures (carry trade). Managed and yield futures ETFs use dynamic trend-following or carry strategies for long or short stocks, bonds, currencies, and commodities. In other words, when it makes sense to own bonds (or things like gold), managed futures and yield futures will own them. When the probability of excess returns is low, they short bonds and gold. Perplexity Stocks, bonds, manage futures, and carry are four non-correlated asset classes. Return Stacked Funds  Trend following = growth stocks (momentum). Carry = value stocks (value/yield).  Return Stacked Stocks & Yield Futures (RSSY)  Relative yield strategy. Yield vs historical yield to determine long or short and position sizing.        Security Name Weightings   iShares Core S&P 500 ETF 74.33%   LONG GILT FUTURE Dec24 42.12%   BP CURRENCY FUT Sep24 28.37%   S&P500 EMINI FUT Sep24 20.02%   EURO STOXX 50 Sep24 17.58%   AUDUSD Crncy Fut Sep24 16.41%   Cash & Other 13.47%   First American Government Obligations Fund 12/01/2031 12.19%   BRENT CRUDE FUTR Oct24 7.83%   WTI CRUDE FUTURE Oct24 7.02%   Low Su Gasoil G Oct24 3.11%   NY Harb ULSD Fut Oct24 2.41%   SILVER FUTURE Dec24 0.20%   NASDAQ 100 E-MINI Sep24 -0.52%   GOLD 100 OZ FUTR Dec24 -1.00%   NATURAL GAS FUTR Oct24 -1.57%   S&P/TSX 60 IX FUT Sep24 -4.04%   NIKKEI 225 (CME) Sep24 -5.30%   JPN YEN CURR FUT Sep24 -5.86%   US LONG BOND (CBT) Dec24 -6.83%   DAX INDEX FUTURE Sep24 -12.64%   COPPER FUTURE Dec24 -13.25%   GASOLINE RBOB FUT Oct24 -13.60%   EURO FX CURR FUT Sep24 -16.77%   US 10YR NOTE (CBT) Dec24 -17.96%   EURO-BUND FUTURE Sep24 -20.37%   FTSE 100 IDX FUT Sep24 -21.48%   US 5YR NOTE (CBT) Dec24 -27.86%   C$ CURRENCY FUT Sep24 -75.14%   Bonds -30.90%   Stocks -6.38%   Commodities -8.85%   Currencies -52.99%   Click to enlarge (Source: Return Stacked ETFs) 75% allocation to VOO not included.  Carry is short bonds, stocks, commodities, and currencies vs the USD. In recessions, bonds increase, and stocks, commodities, and currencies (vs USD) fall. Carry has a modestly bearish positioning (recessionary positioning). Return Stacked Stocks & Managed Futures (RSST) RSST: A Potential 13.5% Yielding Alternative To JEPI I'm Considering Buying       Security Name Weightings   US 5YR NOTE (CBT) Dec24 101.31%   iShares Core S&P 500 ETF 75.47%   S&P500 EMINI FUT Sep24 41.93%   EURO FX CURR FUT Sep24 31.75%   US 10YR NOTE (CBT) Dec24 22.48%   EURO-BUND FUTURE Sep24 20.72%   LONG GILT FUTURE Dec24 18.31%   GOLD 100 OZ FUTR Dec24 13.35%   First American Government Obligations Fund 12/01/2031 12.94%   BP CURRENCY FUT Sep24 12.80%   Cash & Other 11.59%   FTSE 100 IDX FUT Sep24 11.54%   EURO STOXX 50 Sep24 7.29%   AUDUSD Crncy Fut Sep24 5.91%   NASDAQ 100 E-MINI Sep24 4.70%   DAX INDEX FUTURE Sep24 3.57%   S&P/TSX 60 IX FUT Sep24 3.28%   COPPER FUTURE Dec24 3.09%   NIKKEI 225 (CME) Sep24 2.02%   SILVER FUTURE Dec24 1.22%   JPN YEN CURR FUT Sep24 -0.08%   GASOLINE RBOB FUT Oct24 -1.13%   NY Harb ULSD Fut Oct24 -1.32%   Low Su Gasoil G Oct24 -1.36%   NATURAL GAS FUTR Oct24 -1.67%   BRENT CRUDE FUTR Oct24 -2.81%   C$ CURRENCY FUT Sep24 -2.85%   US LONG BOND (CBT) Dec24 -31.92%   US 2YR NOTE (CBT) Dec24 -167.37%   Bonds -36.47%   Stocks 74.33%   Commodities 9.37%   Currencies 47.53%   Click to enlarge (Source: Return Stacked ETFs) 75% allocation to VOO not included. RSST's trend-following strategy is short the dollar, long commodities, short bonds, and very heavily long stocks. In other words, RSSY is positioned for a growth scare to continue, and RSST is positioned for a \"risk on\" bull market to continue. Dynamic Beta Managed Futures (DBMF): The Most Popular (Most Assets Under Management) Managed Futures ETF       description pct   MFS - MSCI EAFE 14.00%   MES - MSCI EMG MKTS 10.20%   GC - GOLD 100 OZ 10.10%   ES - S+P500 EMINI 10.00%   EC - EUR FX CURR 3.00%   US - US LONG BOND -0.30%   CL - WTI CRUDE OIL -3.40%   TY - US 10YR NOTE -15.00%   TU - US 2YR NOTE -15.50%   JY - JPN YEN CURR -44.40%   Bonds -30.80%   Stocks 34.20%   Commodities 6.70%   Currencies -41.40%   Click to enlarge (Source: DBMF Watch) DBMF is short bonds, long stocks, long commodities, and long the dollar. It's positioned for a neutral economy. Mount Lucas Managed Futures (KMLM) Best Performing Hedging Asset In Bear Markets Since 1988 Dividend Kings Portfolio Optimizer Tool In the six bear markets since 1988, KMLM (which tracks the Mount Lucas managed futures index) has had the best returns, averaging 32% gains vs a 32% S&P decline.   Portfolio Visualizer This asset allocation table is built using KMLM's average bear market performance. Its correlation to the S&P during bear market lows (peak panic) is -0.82, about 2X more negative correlation to the S&P than bonds or any other hedging strategy. Since its inception on Jan 2021, its downside capture ratio has been -70%. That means when the market is down, KMLM is up. If the S&P is down 10%, it's up 7%.       Description Percentage   Cash 31.20%   CAN 10YR BOND FUT SEP24 26.20%   LONG GILT FUTURE SEP24 26.10%   EURO-BUND FUTURE SEP24 23.80%   US 10YR ULTRA FUT SEP24 21.00%   BP CURRENCY FUT SEP24 16.60%   Treasury B 08/29/24 15.00%   Treasury B 09/03/24 15.00%   Treasury CMBR 10/03/24 14.90%   Treasury B 09/26/24 14.90%   Treasury B 10/15/24 14.90%   GOLD 100 OZ FUTR DEC24 6.90%   EURO FX CURR FUT SEP24 5.60%   CHF CURRENCY FUT SEP24 4.00%   JPN 10Y BOND(OSE) SEP24 3.80%   COPPER FUTURE DEC24 2.30%   CANADIAN DOLLAR -1.10%   BRITISH STERLING POUND -1.10%   LIVE CATTLE FUTR DEC24 -1.50%   EURO -1.80%   JAPANESE YEN -1.80%   AUDUSD CRNCY FUT SEP24 -2.40%   WTI CRUDE FUTURE DEC24 -2.80%   NY HARB ULSD FUT SEP24 -6.30%   SOYBEAN FUTURE NOV24 -6.40%   SUGAR #11 (WORLD) OCT24 -6.40%   WHEAT FUTURE (CBT) DEC24 -6.60%   CORN FUTURE DEC24 -6.70%   NATURAL GAS FUTR DEC24 -7.20%   JPN YEN CURR FUT SEP24 -10.30%   C$ CURRENCY FUT SEP24 -16.50%   Bonds 175.60%   Stocks 0%   Commodities -34.70%   Currencies -8.80%   Click to enlarge (Source: DBMF Watch) KMLM is positioned for a deflationary environment, short commodities, long bonds, and neutral the dollar. It avoided stocks by design to avoid being long stocks in the early days of bear markets. Simplify Managed Futures (CTA): Best Hedging Power Since Inception Portfolio Visualizer CTA uses only commodities and bonds because management says their backtests indicate that this creates the best hedging and trend-following results. Historical Returns Since April 2022 PortfolioThus far, CTA has achieved better returns than its most popular ETF peers. Portfolio Visualizer CTA's historical downside capture ratio of -82% means it has the most hedging power since its inception in March of 2022. Thus far, it has delivered the greatest upside in down markets, which is why I combine it with KMLM for 40% of my portfolio, dominating the hedging bucket. So, what does CTA own? Simplify Simplify CTA's most significant positions are long gold, short canola oil, and slightly long cocoa. It's short Canadian bonds but long US bonds. It's neutral short-term rates and slightly short commodities.  CTA appears to be short bonds and commodities, transitioning between bullish (risk-on) and bearish (risk-off) positions.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2462453345"}