2023-06-15 16:06:17 ET
Summary
- The Treasury will soon need to sell around $1.2T in bonds to replenish its depleted account following the debt ceiling agreement.
- With foreign institutions, the Federal Reserve, and US commercial banks all avoiding Treasuries, it seems unlikely that sufficient demand for these new auctions will be adequate.
- Potential crude oil dynamics may push inflation higher, while most recession risks already appear priced into the bond market's inflation outlook.
- BND may be an excellent short opportunity today due to the convergence of bearish catalysts, with put options being an attractive way to bet against the fund.
The US Treasury market dodged a bullet two weeks ago after Congress finally made a debt ceiling agreement just days before potential default. Now, the government has a debt agreement that lasts two years while materially increasing the government's spending capacity through 2025. There is no longer any immediate risk of a US government default; however, major US credit rating agencies continue to have a negative credit rating outlook as the drama threatens the Treasury's global perception of stability. More importantly, because the Treasury's balance declined during the first half of the year, it will need to issue bills much faster to recoup around $1.2T in drawdowns .
In my view, considering the strained state of US commercial banks and the lack of international demand for Treasuries, this rapid debt sale plan would spur more considerable liquidity risks in the bond market. In 2020, when the Treasury balance was nearly as low, it was heavily supported by immense QE money-creation, significant bank demand, and substantial investment demand as investors shifted away from stocks toward bonds. Today, the Federal Reserve is selling Treasuries, banks generally have insufficient solvency to buy more (after losing significant sums on their 2020 purchases), and secondary market demand is not very strong. That said, low inflation and recession risks may mitigate those burdens. If retail demand for Treasuries is sufficient, the US government may manage to raise this capital without creating more significant losses in the bond market.
I have generally held a bearish outlook on Treasury and corporate bonds for the past two years, seen through the Vanguard Total Bond Market ETF ( BND ). I covered that fund last in February in " BND: Inflation May Fall, But It Won't 'Return To Normal' This Decade ," detailing my view that core inflation should remain above target levels for years. Inflation is slowing, but not nearly as fast as many had hoped, particularly compared to the recessionary state of the global manufacturing economy. The bond market continues to price in a more considerable decline in inflation when it may already be reaching its cyclical bottom or is coming closer to that point. Considering the state of the oil market (the primary inflation driver), I believe there is a strong catalyst for an increase in the inflation outlook over the coming months. Combined with the rapid rise in Treasury auctions, BND may have an exceptional bearish opportunity today.
Nobody Wants Treasuries, But Will Retail Buy?
The primary owners of the Treasury market are foreign institutions (around half), the Federal Reserve, US commercial banks, and retail investors. Most foreign institutions are less interested in Treasuries today, with China lowering its exposure to longer-term Treasury bonds. Japan, the other primary owner, has also decreased exposure and will likely accelerate sales once its yields rise. The US Federal Reserve allows its Treasury exposure to decline as its bond holdings expire (or quantitative tightening). US commercial banks also sell Treasuries due to solvency strains following significant off-balance sheet losses on bonds purchased from 2020-2021 . US retail investors sold bonds ahead of the larger institutions during 2021 (as stock allocation grew) and are starting to buy back today. See below:
Overall, the Treasury market is dominated by sellers, with individual investors being one of the few areas with growing demand, likely due to the much higher bond yields. Looking forward, the Federal Reserve and US commercial banks are essentially guaranteed to be net bond sellers because the money supply is declining due to QT at an accelerating pace. These trends are generally significant for Treasuries, but they also exist for investment-grade corporate bonds, such as those which make up around a third of BND's assets.
If most prominent institutions are selling bonds (or at least not buying them), can individual investors foot the bill for the coming wave of Treasuries? Significantly, the bond market may have stabilized in 2023 because the US Treasury has been unable to sell more bonds. In my view, the coming sharp reversal of that trend, combined with lackluster institutional demand for bonds, makes it likely that bond yields will need to rise higher for sufficient individual investors to foot the Treasury's massive liquidity needs.
Bond Yields are Low Compared to Inflation
BND is now much more attractive than 2020 and 2021, with an effective yield-to-maturity of 4.6%. BND's effective maturity is currently 8.9 years, and its duration of 6.5 years, meaning a 1% rise in its yield will push BND's price down by ~6.5%. The credit risk in BND is negligible, outside of potential downgrades to its BBB corporate bonds (~14% of assets) and, although less likely, its Treasury bonds (two-thirds of its assets). The much more considerable risk to BND is a rise in its yield, which could cause an asymmetric decrease in its price.
On the one hand, many investors may see its 4.6% yield as "high" because low-credit risk bonds have not paid such high yields since the 2000s. However, compared to today's 5%+ core inflation rate, BND's true returns are historically very low. See below:
As you can see, BND investors are losing around 1.7% in value after core inflation (not including taxes) per year. Of course, BND's pricing accounts for the expected decline in inflation over the coming year. Based on inflation-indexed bonds, the Treasury market is currently pricing for a ~2.2% average inflation rate over the next five years. If true, BND's yield could be higher than expected inflation. That said, inflation has generally run higher than expected over the past year, despite a significant slowdown in manufacturing economic activity.
Of course, expected inflation is primarily a function of manufacturing activity and oil prices. See below:
The price of crude oil has declined significantly since 2022 due to mild improvements in production and moderation to demand - caused by slowing manufacturing activity. The manufacturing PMI suggests that US manufacturing activity is slowing at a very fast pace, signaling a larger decline in demand. However, the rate of its decline should not fall much further as the PMI reaches its typical historical minimum. To me, these data imply that inflation has only declined due to a relatively significant decrease in manufacturing activity and oil prices (which push transportation and production costs).
As detailed in " Valero: U.S. Gasoline Prices Will Soar This Decade As More Refineries Shutter ," it looks pretty likely that the total supply of crude oil and fuel products will decline over the coming year - due to immense CapEx declines from energy companies since 2020. Since oil is currently priced below breakeven (profit) levels for new wells, energy producers are racing to decrease output (after accelerating production with high prices last year). Due to the 2021 shortages and the SPR drain, US oil in storage is at extreme historic lows, creating the potential for a considerable price increase should deficits return. Even more, OPEC members voluntarily reduce production and may mandate further cuts soon due to low prices .
Overall, oil demand may have already seen its impact from slowing manufacturing activity, while global and domestic supplies appear likely to turn sharply lower. I believe this has created a "perfect storm" for a more significant spike in oil, fuel, and most commodity prices. If that occurs, inflation expectations in the bond market will surge, pushing BND even lower as investors' bond returns decline.
The Bottom Line
I have generally held a bearish outlook on BND over the past year; however, I am currently more bearish than when I covered it last February. I believe any benefit the fund may see from a recession has already occurred due to the sharp declines in oil and manufacturing activity. In other words, while the US economy is not officially in a recession, the bond market has already benefited from the bulk of the typical "disinflationary" patterns in slowdowns. Once again, producers (of commodities and other goods) are lowering output levels to offset depressed demand, potentially meaning inflation could spike back up later this year.
The primary "X factor" is economic demand, as a continued decline in business and household demand may offset falling production levels sufficiently to keep inflation moderated. However, in my view, the US government and Federal Reserve's consistent efforts to stimulate demand (they have little control over supply) imply it is unlikely demand falls faster than supply. Considering a contentious presidential election will occur in 2024, the current dominant party seems likely to support stimulus efforts should a recession officially occur - even if that stimulus risks worsening inflation. The reluctance to decrease fiscal spending in the recent debt deal is another strong indication of that.
Overall, I believe BND has a "perfect storm" of negative catalysts today, with few strong positive ones. A significant decline in stocks is unlikely to aid BND because the fund has become positively correlated to stocks (due to higher inflation). Since BND may only fall by 5-10%, it is not a great short opportunity; however, longer-term put options are means for speculators to earn an asymmetric profit potentially should BND fall. BND's implied volatility is extremely low today at 5.9%, near its lowest implied volatility level this year. Accordingly, put options on BND are historically cheap, particularly if its volatility level rises over the coming months, as I suspect. Of course, if BND fails to decline sufficiently (potentially due to a larger-than-expected decline to core inflation), such options may expire worthless, so investor discretion is advised.
For further details see:
BND: Why The 'Debt Deal' Could Be Very Bearish For Bonds