[Market Outlook] Rates and Bonds
Summary
This is a repost of an article provided to our investment community at Seeking Alpha.
The main purpose is to provide our outlook and action plan given the odds of further rate hikes after Powell’s recent comments.
You have good reasons to be concerned about a recession. The yield curve remains inverted – at the deepest unseen level since the 1980s.
Here I want to remind you about the limitations of this popular signal before taking action.
After all, what gets us into trouble is not what we don't know. It's what we know for sure that just ain't so.
Toward the end, I will also describe a few other alternative signals and our investment actions (especially in bonds).
Yield-curve inversion and its limitations
With the recent comments from Powell, the rates and the inverted yield curve is the top concern of many of our members. Indeed, most investors are familiar with the dreaded yield curve inversion as shown below (a plot of the spread between 10-year treasury rates and 2-year treasury rates). As seen, the yield curve remains inverted – at the deepest unseen level since the 1980s.
Also as seen, since the 1970s, there were six recessions (highlighted by the great bars). And all six had been preceded by a yield curve inversion. So, the success rate of this signal is 100% in the past 50+ years.
Given the popularity of the yield-curved signal and hence the heightened anxiety we’ve seen among our members, we feel timely to point out the limitations too. As detailed in an earlier article,
1. The sample size of past recessions is too limited to be statistically significant. As mentioned above, there were only 6 recessions in the past 50+ years. Expanding the timeframe broader, there were 19 noteworthy recessions throughout U.S. history.
2. The signal does not always work. There had been both false positives and false negatives even among the limited sample set. Some recessions happened without a preceding signal, and vice versa.
3. The signal does not tell you when a recession would happen. Many times, the equity market has staged substantial rallies AFTER the signal occurs for an extended period of time. In the long term, missing out on such rallies hurts more than avoiding the recessions (even if you indeed manage to do so).
Finally, and most importantly, the signal is binary. As such, it offers little actionable guidance. Investors cannot go all-out of equity because the yield spread dipped below zero (like in April 2021 when the yield curve first became inverted) and then come back to equity when the yield spread surfaces above zero a few days later.
Investors need signals that provide more granularity. And we will describe two simple ones that you can obtain from publicly available data immediately below.
Alternative signal #1 – BAA yield spread
As mentioned in our recent updates, the yield spread between BAA bonds and Treasury Rates (“SBAA”) is another signal that we closely watch. It has narrowed to the 1.7x% range lately – a bit narrower than what we deem as “normal”. The key idea is that the SBAA now provides a nonbinary. As mentioned earlier, gamma, is our main risk gauge based on SABB. The narrowing of SBAA finally pushed gamma to be below 1. It is at 0.96, not that far below 1. And you can see the value of the granularity provided here. Rather than telling us to go all-out or all-in of equity/bonds, it tells the DEGREE to go out and go in.
Alternative signal 2 – Cash position
You know that our investment decision consists of a few simple decision points. Only 3 in total really. First, how much cash to hold? Second, for the capital to be deployed, what is the equity-to-bond ratio that we should maintain? And third, should we use leverage, and if so, how much?
The second and third decision points are based on the yield spread and gamma parameters discussed above together with a few other things such as SP500 valuation and market volatility as detailed in our earlier communications.
Here, I will just focus on the first decision point based on a simple exposure index (“EI”) derived. The underlying idea here is simple. The EI is defined as the summation of stock yield and bond yield, thus providing an overall measure of the opportunity cost of holding cash. If the EI becomes higher, I will reduce cash because I could earn a higher yield either from bonds, equity, or both. And vice versa.
Against this background, you can see that the current EI is quite attractive. The EI has been in a range between about 2.5% to 5.5% since 2010. And an EI of 5% or above was reached 3 times only since then: in 2010 and 2011 when both equity and bonds were quite attractive. The current EI of 5.5% (a dividend yield of ~1.6% from SPY plus a 10-year treasury rate of almost 4%) is near the top level since 2010.
And as a result, we are NOT holding a lot of cash despite the warning signs we saw above. As updated in our monthly portfolio maintenance, we are holding about 4% cash in our Survival and Withdraw portfolio only.
Our bond/cash holdings
We of course do not park the 4% cash allocation in “cash”. We see the current conditions as a good opportunity to allocate a good part of it to short-term bonds – which I see as cash equivalent. And here are some of the bonds that we are holding now. As seen, we hold them in a staggered fashion in their maturity dates. They are offering an average of 5% yield in the next few months – which is approaching the long-term average return of SP500 under current valuation multiples. As mentioned a while ago, the treasury I bond is also attractive. Its current yield is almost 7% - but there are limits on the amount you can purchase, and the time horizon is also a bit longer than these following short-term corporate bonds.
As communicated, we are monitoring these key parameters closely. Some of the key trigger points for us are:
· When/if the EI becomes even higher (say 6.0% or above) and gamma becomes larger than 1.0, we plan to further reduce our cash reserve to a minimum and increase our position either in bonds, or equity, or both.
· And when/if the EI reaches 7.0% (which is the EI reached during the 2008 Great Recession) and gamma becomes larger than 1.2, we will start considering increasing our leverage.
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