Want A Contrarian Idea? Accumulate Long-Term Government Bonds

Against a backdrop of spiraling inflation concerns and banks (i.e. JP Morgan) predicting up to nine Fed rate hikes, longer dated US Government Bonds are potentially entering a zone where they are attractive over the next several months. The secret to this trade is that the US economy may soon enter a significant growth slow down due to both fiscal and monetary contraction. The bond market is hinting at this as everyone focuses on geopolitics and inflation. This is not a 1982 call-to-action investment in government bonds, particularly against the backdrop of negative real yields, but in the medium-term we believe there to be an excellent tactical allocation opportunity.

From a fundamental perspective there are several reasons to expect a buying opportunity. First, looking at the changing economic backdrop going into the second quarter, we estimate that the United States will be entering into a mini deflationary period, where both the year-over-year change in CPI and GDP will be lower than in the current period. These periods of deflation, whether dramatic or insignificant, are periods where risk premiums in pro-cyclical assets such as stocks, corporate bonds, and commodities tends to increase to adjust for the slowing period of growth. Long bonds act as the asset of choice during these periods as inflation premiums, term premiums, and risk neutral yields all fall, and investors look for risk-free cashflows.

Secondly, while at this point inflation has undoubtedly touched every part of our economy, policy makers on both the monetary and fiscal policy front have come to understand the threat and are taking measures to control inflation. On the fiscal policy side, members of the Democratic Party, such as Joe Manchin, have put a stop to runaway government spending, for the time being. On the monetary policy side, the Federal Reserve is in complete consensus to begin raising interest rates immediately at the next meeting in March, stop quantitative easing, and shrink the Fed’s balance sheet starting in the first half of this year. The combination of these measures along with skittish consumer sentiment could lead to a rapid deceleration in growth.

In reaction to the Fed moving to a hawkish monetary policy stance, bond investors have stopped bidding up longer dated inflation expectations and been flattening the yield curve. This says that the bond market believes the actions that the Federal Reserve is about to take are enough to prevent inflation from becoming a long-term entrenched issue, and may in fact even harm economic growth. Also, the 20-year relationship between stocks and bonds remains in place. Generally, government bond prices and stock prices continue to move in opposite directions.

Taking stock of where sentiment is, using CFTC Commitment of Trader Data, we can see that speculators are reaching a point of maximum pessimism in the bond market. Traditionally, maximum pessimism coincides with a pending market reversal, or at least a halt in the current trend, as the market runs out of marginal speculators to bet against bonds. This leaves the structure of the market vulnerable to changes in narrative.

In the chart below is the 10-Year Treasury Bond Future Total Return, plotted against the rolling Z-score of CFTC position data for 10-year bond futures. At the bottom of the image is the rolling maximum drawdown of the 10-Year Treasury TR Index. As you can see from the chart, periods of maximum pessimism coinciding with large drawdowns normally mark periods of future gains for the 10-year Treasury Bond. We may be entering just such a period.

Consistent with our view that stocks and bonds will be hard pressed to provide returns like the last decade (The 10-Year Crystal Ball Shows Us Changing Asset Allocation Models (forbes.com), the long-term expected return for US Treasury Bonds is muted. However, in the medium term, when lining up the economic backdrop, the technical, and the fundamental, there is a real case to be made for a trade to lower long-term government bond yields. Be a contrarian and, provided you can assume the risk, accumulate long-term government bonds on dips.

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