2024-01-08 16:28:32 ET
Summary
- Changes in long-term inflation expectations and real interest rates have driven bond market volatility.
- The correlation between crude oil storage levels and the price of bonds is notable, pointing toward shortage risks creating more inflationary pressures.
- The potential impacts of oil prices, currency fluctuations, and the Federal Reserve's actions are essential for bond performance in 2024.
- With the Federal Reserve making a dovish pivot and real rates slipping, BND has no immediate bearish indications.
- In the long run, I still see a downside in BND associated with the potential "surprise" inflationary rebound in the services sector.
The most critical market volatility over the past two years has not been in stocks but in bonds. 2022 saw the worst year for long-term bonds in US history, with the second worst being as far back as 1803 during the Napoleonic Wars. For the most part, 2023 was also a challenging year for bonds, with most long-term bonds seeing continued losses last year, albeit ending the year with a solid finish. The chief cause for the volatility in bonds has been changes to long-term inflation expectations and real interest rates, both factors having turned a corner in recent months.
I was bearish on the bond market ETF ( BND ) going back to mid-2020 when I believed the stimulus efforts that year would spike inflation and eventually cause significant long-term bond sales. I maintained a bearish view through the beginning of September of 2023 , with the fund losing an additional 4% over the following month and a half, one of its most rapid drawdowns in 2023. While I have not covered BND since then, I did cover the long-term Treasury ETF ( EDV ) on October 20, 2023 , which has very similar fundamentals, giving the ETF a rating upgrade on nearly the day of its trough. Though I was neutral on EDV during the upgrade, it has risen by a staggering 26% since then, with BND recovering by around 6%.
BND is now just above the price when I covered it last. As we begin the new year, it seems like a good time to cover it again, particularly considering my rating upgrade on long-term Treasuries, which are the primary driver of BND's volatility. I believe bond market volatility may continue to quieten in 2024, with more volatility expected in stocks. That said, changes in commodity prices remain the primary potential driver of changes to bond prices.
Is the "Bond Bear Market" Officially Over?
I upgraded my EDV outlook in October to neutral from very bearish because long-term Treasuries were effectively pricing in a 3-4% inflation rate over the next two decades, which is a high figure. That said, I continue to view long-term bonds skeptically. In the short term, they had become oversold by October, considering commodity prices had not risen as I had expected. This is important as my views regarding bonds are highly intertwined with the outlook for oil, considering it significantly impacts inflation expectations. Fundamentally, my bearish view on bonds is predicated, in part, on my bullish view on oil.
Those who follow my work may note that my bullish oil outlook is a significant area where I have been wrong, or at least not right, given oil has remained stagnant despite the seemingly bullish catalysts in the Middle East. This will be explored in other articles; however, it will be essential to take note of its potential impacts on BND. Still, even if oil remains cheap, I believe it is doubtful we see a permanent shift back to sub-2% inflation over a multi-year period. That could undoubtedly occur in a recession for a year or maybe two. Still, I fundamentally believe that the era of 2% inflation is now firmly in the rear-view mirror, significantly limiting BND's upside potential.
BND has an effective maturity of 8.7 years, so the Treasury market's ten-year average inflation expectation rate (the spread on bond fixed rates and inflation-secured Treasury bonds) significantly drives its price. There is a robust correlation between the inflation expectation rate and the price of crude oil. There is also an inverse correlation between crude oil stocks (storage) and oil price and an inverse relationship between the inflation expectation rate and the price of BND. Thus, there is a positive relationship between BND and oil stocks, though the association is highly indirect. See below:
It is still interesting to note that the ebbs and flows in BND since 2020 have been tightly correlated to crude oil storage levels. This is essential because less stored oil is associated with shortages, which increase inflation. Crucially, the oil market is outside the Federal Reserve's purview. The Fed can alter interest rates to change economic growth and savings levels, but it cannot print oil, which is the primary driver of inflation in transport-centric economies. Thus, if there is insufficient oil production compared to demand, prices will rise, which is not necessarily associated with overall economic supply and demand.
For example, it is expected that oil will fall in a recession. Still, if a downturn comes with other external risks, such as in COVID lockdowns or the current geopolitical crises, the opposite may be the case. Indeed, should the US economy slow, sinking the value of the US dollar, there is also a greater risk that OPEC or BRICS countries will have incentives to move away from the US dollar, potentially upsetting the " petrodollar " system, resulting in higher oil prices due to lower currency value. Of course, currency declines are also a direct inflationary factor. The US dollar was firm in 2023 but is showing some signs of reversal today:
While a US dollar decline is technically inflationary, that is only true from a long-term perspective. I believe a rapid move from the US dollar by BRICS or OPEC countries would be particularly inflationary in the short term due to the potential commodity and trade impacts. Such would also likely result in countries like China selling Treasury bonds faster, which is already indirectly weighing on BND's value.
That said, the exchange rate is closely associated with the real interest rate, which is the rate on Treasuries after expected inflation. A lower real interest rate will generally improve BND's value and vice versa, with the rise in real rates being the primary negative catalyst for BND in 2022. The real rate is potentially falling today as the Federal Reserve becomes more dovish, directly promoting BND's reversal since October, aligning to a slight US dollar depreciation.
These relationships are crucial to understanding how BND and other fixed-income assets may perform in 2024. In the short term, the small dovish pivot and a slight slowdown in US economic demand are certainly bullish for BND. However, should the Fed become too dovish or the US economy slow too much, then that could, in fact, be very bearish for BND by way of creating currency volatility, exacerbating the US deficit, or encouraging QE, all of which contributed to the inflation spike we saw after 2020. Indeed, if we totally exclude commodity impacts by focusing on services CPI inflation (i.e., not goods), we can see inflation may already be rebounding on a monthly basis:
Services Inflation CPI MoM (Federal Reserve Economic Database)
In my view, this could be one of the most important charts to consider today. Most investors and analysts believe that inflation is now in the rear-view mirror. However, if we exclude potential commodity impacts entirely by focusing on services (the primary spending portion for most Americans), we can see signs of a rebound or at least no apparent signs of disinflation over the past six months. Thus, should commodities rebound, or at least not decline, then inflation may also do so, pointing to a higher inflation expectation rate, hampering BND's value.
The Bottom Line
My 2024 outlook for BND is not as black and white as it was the three years prior. In the long term, I believe the BND will continue to decline due to a long-term inflationary shift in the structure of Western economies. This is due to the need for high inflation due to excess debt levels and falling purchasing power toward "the global south," the following exporters of most commodities. As those countries look to move away from US dollar hegemony, and the US Federal Reserve has some reason to allow for 3-4% inflation (to lower real debt levels), it seems that bonds are not a great return given they may underperform the CPI. That issue is particularly true for longer-term Treasuries, with BND's bonds being somewhat long-term.
Of course, BND could also face losses if credit spreads widen, which almost always occurs during economic slowdowns. BND may also face more rapid drawdowns in oil rises or other geopolitical or external factors that lead to supply and demand gaps. Thus far, the container shipping crisis in the Red Sea is not large enough to create that shock in the US (though potentially in the Mediterranean), but if that issue spreads to tankers and dry bulk , then it would be inflationary. Still, this risk to BND is offset by the likely declines in real interest rates associated with the Fed pivot and the encouragement of a slight recovery in BND.
Overall, I am neutral on BND with a slightly bearish long-term view. In my opinion, the recovery we've already seen in BND fully accounts for the slight dovish pivot. It is certainly possible that BND will continue to rise, but I do not expect it will return to previous highs since the interest rate and inflation complex seem unlikely to normalize entirely. Outside of external inflationary catalysts, I do not expect BND to suffer significant losses soon. However, that could easily change if we see crude oil or other essential commodities begin to rise without reversing. Indeed, to me, this relates to the "straw that breaks the camel's back," with a potentially small event sufficient to trigger another considerable rise in inflation.
For further details see:
BND: The 2024 Bond Market Should Be Quiet Unless Another Straw Hits The Camel