AQNU - All Roads Lead To Lower Bond Yields

2023-11-16 08:05:00 ET

Summary

• A leading economist recently stated that "all roads lead to lower bond yields."
• We point to five major reasons why bond yields are headed lower in the near future.
• We also share some of our top picks to profit from the evolving market landscape.

The dominant stock market theme since the beginning of 2022 has been the rapid rise in interest rates as part of the Federal Reserve's war on inflation:

However, this all appears set to change, with factors lining up to make a very strong case for lower bond yields moving forward. As leading economist David Rosenberg recently pointed out :

Everything I'm looking at: the home affordability ratio, that's a mean-reverting ratio that has to include lower interest rates in the coming year, the equity risk premium has to include lower rates in the coming year or so, all roads lead to lower bond yields ...I think that the long bond is going to be the place that you want to have money in for the next 12 months.

In this article, we will explain why we agree with David Rosenberg's assessment and then share some of the ways that we are positioning our portfolio to profit from this expected market shift.

#1. Low Home Affordability Ratio

The home affordability ratio seeks to capture the financial feasibility of purchasing a home at a given point in time by providing the ratio of a household's income to the cost of homeownership (including mortgage payments, property taxes, insurance, and expected maintenance expenses).

By its very nature, the home affordability ratio is considered mean-reverting because, at a certain point, the cost of homeownership relative to income rises to a point that it becomes unsustainable. When housing costs are relatively low compared to income, it often signals an oversupply of homes or lower demand. Conversely, when affordability is low due to rising housing costs relative to income, it can lead to decreased demand and price corrections as potential buyers are priced out of the market.

Poor home affordability can point to lower interest rates in the future due to the relationship between interest rates and housing affordability. When affordability is low, central banks and policymakers may respond by implementing monetary policies aimed at reducing interest rates. Moreover, a lack of affordable housing reduces demand for housing, thereby reducing demand for mortgages, which in turn exerts downward pressure on mortgage rates over time.

#2. Falling Inflation

Falling inflation is another key indicator that often points to lower interest rates in the future. In the current environment where interest rates are at restrictive levels intended to combat inflation, a meaningfully declining inflation rate signals that the Fed can now move to cut interest rates from restrictive levels and move them towards a more neutral position in order to keep inflation near the Central Bank's long-term 2% target. Given that inflation is clearly in decline, it appears highly likely that the Federal Reserve will cut interest rates from restrictive levels sooner rather than later:

#3. Economic Downturn

The Fed typically uses interest rates as one of its primary tools for influencing economic conditions, and when economic activity is slowing, it may lower rates to stimulate investment and spending, boost consumer confidence, and reduce debt burdens on financially distressed corporations.

#4. Negative Equity Risk Premium

The equity risk premium ("ERP") quantifies the additional return investors expect to receive for holding stocks or equities over and above the risk-free rate that is earned by investing in government bonds. As a result, it measures the compensation investors require for taking on the higher volatility and uncertainty risks associated with equity investments. The equity risk premium is considered mean-reverting because it tends to revert to its historical average over time due to the market working through various scenarios that can temporarily displace it from what is widely considered to be an appropriate premium.

When the ERP is high, it signifies that investors are demanding a larger premium for the risk associated with equities, possibly due to concerns about economic uncertainty, corporate earnings, or geopolitical factors. Conversely, when the ERP is low or even negative, it suggests that investors are relatively optimistic about the equity market's prospects. In such scenarios, investors are willing to accept lower relative returns in exchange for the perceived higher risk of holding equities. This optimism can result from positive economic indicators, strong corporate earnings, or other favorable market conditions.

A negative equity risk premium, where the earning yield on equities is lower than the risk-free interest rate, can signal expectations of lower interest rates in the future because it suggests that investors are willing to accept a lower return on equities compared to the guaranteed return offered by risk-free assets like government bonds. This preference for lower equity returns often coincides with expectations of central banks lowering interest rates to stimulate economic growth or provide support during periods of economic uncertainty.

Given that major indexes like the S&P 500 ( SPY )( VOO ) and Nasdaq ( QQQ ) currently have negative equity risk premiums, it appears that the market is expecting that we are either in store for a period of very robust earnings growth or that interest rates are going to head sharply lower. Given the slowing economy and falling inflation, it appears that the latter is what the market is pricing in.

#5. Heavy Government Debt Burden

Last, but not least, the heavy debt burden on the U.S. government is likely to pressure the Fed to cut rates sooner rather than later as well. This is because U.S. interest expenses are rising rapidly due to the recent rapid rise in interest rates. As a result, the cost of servicing this debt is chewing up a higher and higher percentage of the government's budget and threatens to crowd out other priority areas of spending such as defense spending and already-underfunded entitlement programs. If the economy were to go into recession, the budget situation would look even more dire as tax revenues would almost assuredly decline and the political appetite and economic justification for tax hikes during a recession would be practically nonexistent. As a result, the only truly viable alternative is to have interest rates plummet - engineered by a combination of short-term rate cuts and a potential resumption of bond-buying by the Fed in order to make the debt burden easier to service.

Investor Takeaway

The financial landscape is rapidly changing, with expectations of lower interest rates starting to take center stage after a recent round of weakening economic indicators and lower-than-expected inflation. Moreover, historically low home affordability and a negative equity risk premium add further strength to the argument for lower interest rates.

As a result, we are increasingly investing in assets like bonds ( BND ), preferred stocks ( PFF )( PFFA ), and investment grade bond-proxy defensive high-yield equities such as real estate investment trusts ( VNQ ), utilities ( XLU ), and master limited partnerships ( AMLP ) like Realty Income ( O ), Enterprise Products Partners ( EPD ), Energy Transfer ( ET ), and Algonquin Power & Utilities ( AQN ). We expect these assets to become more attractive in a low-interest-rate recessionary environment due to their potential for generating income and offering relatively stable returns.

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