Zero-Coupon Bonds Will Soar When Rates Finally Fall
A few things are taking shape within the financial markets where investors should consider what lies ahead for bond yields and how to profit from the bond market as opposed to the stock market. Let’s start with Fed Chair Jerome Powell noting in his post-Federal Open Market Committee (FOMC) presser that the Fed is seeing several inflation indicators moving in the right direction, which in my view, was the green light for stocks to advance.
The Fed’s stated target for inflation of 2% almost sounds like a pipe dream given the cost of housing and the strong labor market, but it sees the cost of interest on the $31+ trillion in U.S. federal debt as a looming judgment day for the dollar if it can’t rein in the cost to carry the debt load until Congress gets clarity on fiscal policy. This will only happen, again in my view, when fiscally minded Congressional leaders on both sides of the aisle agree that doing nothing will bankrupt the government and bring about a historical reset of biblical proportions.
It’s hockey stick charts like the one below that must keep the roughly 400 PhDs at the Federal Reserve up at night. I think Powell’s strident commitment to getting inflation back to 2% is rooted in a quote from Albert Einstein: “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
If the Fed intends to deconstruct the embedded inflationary forces of the past 18 months, it will have to orchestrate the unemployment rate getting up to around 4.5%, which implies the loss of about 1.8 million jobs. This would indeed amplify the notion that the current pause in Fed monetary policy is temporary.
While I agree that inflation is moving in the right direction, the bump in retail sales and consumer confidence data sends a clear message, that despite $17+ trillion in household debt, the reactivation of student loan payments and credit card rates pushing above 20%, the cheapest average ticket price to see Taylor Swift is $969 in sold-out venues. The highest prices average $20,503, according to www.stubhub.com.
There seems to be a real disconnect in what the average U.S. consumer is facing in the next year. Case in point, Home Depot CEO Ted Decker stated in a recent CNBC interview that the #1 home retailer was expected to see sales decline by 2-5% compared to 2022 and earnings fall by 7-13%. Now, to rationalize this to some extent, Home Depot enjoyed an explosion of 47% sales growth and 60% earnings growth during the pandemic period. So, a pullback and shift in spending to experiential and services make sense, but not when it’s on borrowed money.
Former Home Depot CEO Bob Nardelli issued a grim warning over the United States’ “very complex” economy, cautioning consumers that middle market companies are under “tremendous pressure.” “I think we’re going to see a lot of bankruptcies. Like Bed, Bath and Beyond.” This is an insightful observation. While the market has rallied on the back of significant optimism surrounding all things AI, stocks of multiple specialty retailers have tanked from bearish forward guidance, running counter to market euphoria, according to www.foxbusiness.com.
I think the commentary from Costco and Home Depot about consumers shying away from big-ticket purchases is somewhat telling about what lies ahead. The chart below of the S&P Retail SPDR ETF (XRT) shows a big Covid-related spike in spending due to trillions in stimulus checks falling out of the sky, followed by what looks to be a now-hunkering down of sorts. It argues well that this summer’s expected spending travel spree will usher in a period of belt-tightening.
Of course, I could be dead wrong and consumer balance sheets will experience some sort of fiscal epiphany, from where I’m not sure, but I would venture to say that Bob Nardelli is probably on point and that recent stresses in regional banks, the Fed seeking to semi-break the economy to hammer inflation to 2% to salvage the national debt crisis bodes well for a deflationary cycle and lower interest rates going forward. The Fed failed to recognize inflation in all its fullness early on, and it is committed to getting it right or else it will imperil the ability of the country to make good on its debt obligations.
Ray Dalio, founder of Bridgewater Capital, the largest hedge fund in the world, stated on June 8 that the U.S. is facing a big-cycle debt crisis and that Treasuries are risky. It’s my view that Ray Dalio has an open line to Jay Powell and they are on the same sheet of music. Progressive spending habits are jeopardizing the future of the U.S., and unless both interest rates and government spending come way down, America will go the way of the Roman empire. It took a while, but it ultimately failed monetarily, culturally and morally. So many people seem jaded by high debt exposure, personally, in business and at the national level. There seems to be so little emphasis on the future.
https://fortune.com/2023/06/08/ray-dalio-bridgewater-associates-us-economy-debt-crisis-recession/
And now for the good news. Assuming common sense prevails at some point, and I think it will when people recognize the free stuff is no longer possible because the government is facing a head-on collision with reality, the Fed will orchestrate an economic slowdown that brings rates lower. In doing so, there is an investment proposition that is more than simply compelling.
About this time a year ago, the 30-year Treasury was yielding around 3.0%. Today, it yields 3.85%. The iShares 20+ Year Bond ETF (TLT) was trading around $118 then, and today, they trade at $102.60 as of last Friday. If the long bond gets back down to 3.00%, then shares of TLT should return 15% from current levels. That’s assuming the Fed gets its way with fighting inflation, and with the $31+ trillion debt elephant in the room, I think it will drill the economy to whatever level it takes to break inflation.
For those with an appetite for more risk, the PIMCO 25+ Year Zero Coupon U.S. Treasury ETF (ZROZ) was trading at $110 back in early June 2022, when long bond yields were at 3.0% and today trades at $91.25. A move back from 3.85% to 3.00% would theoretically return 21% in shares of ZROZ. Not bad, considering potentially high-performance alternatives to lofty year-to-date stock market returns.
If the Fed does, in fact, achieve its 2% target rate of inflation and long-term rates drop below 3%, then the returns on long-term zeros get into OMG territory, where 50% gains are a plausible scenario. At this juncture, this is a watchlist situation, but when, and if, the data fall into place, and it may be sooner than we all think, it will make compelling sense to lock and load up on zeros.
My view is the Fed has no choice but to drive rates lower to avert chaos at the governmental budgetary level. In doing so, there is some serious money to be made from a slowing economy, being in the right instrument.
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