2023-09-27 02:12:53 ET
Summary
- The Vanguard Extended Duration Treasury ETF holds 20- to 30-year Treasury STRIPS which have an extremely high duration.
- After a major decline, the EDV now yields 4.7%, and with tight monetary policy beginning to undermine equity markets, it is time to lock in these high yields.
- Falling risk assets could trigger a flight to liquidity, driving down inflation expectations and real bond yields, leading to a surge in the EDV.
- Rising bond supply is the main downside risk, but if policymakers do not take steps to narrow the deficit, then the Fed may be forced to set a cap on bond yields to the benefit of the EDV and the expense of the dollar.
The Vanguard Extended Duration Treasury ETF ( EDV ) holds a portfolio of 20- to 30-year Treasury STRIPS, which represents a single coupon or principal payment on a US Treasury security that has been stripped into separately tradable components. These securities promise a single payment upon maturity in the next 20-30 years, without any interim coupon payments. As a result of the lack of coupon payments, the fund has an extremely high average duration relative to most bond market ETFs, at 24.3 years.
I previously took a neutral stance on the EDV in June owing to near-term risks stemming from the continued rise in equity prices, which threatened to keep the Fed hawkish for longer than expected. With the EDV's yield to maturity rising a further to 4.7 since then and stocks appearing to buckle under the pressure of increasingly tight monetary policy, it is now time to increase exposure in my view as a move lower in both inflation expectations and real yields looks likely.
Yield Is Significantly Above GDP Growth Outlook
Long-term bond yields tend to track the long-term nominal GDP growth as high GDP growth raises the required return on risk-free assets and interest rates are expected to rise to reflect this, and vice versa. While the current yield on 20 and 30-year STRIPS is still below the Fed funds rate, at 4.7% it is higher than the trend rate of nominal GDP growth.
US 30-Year UST Yield, 30-Year Breakeven Inflation Expectations, and 30-Year Real Yield (bottom) (Bloomberg)
According to the yield spread between regular Treasuries and inflation-linked Treasuries, investors anticipate inflation to average 2.4% over the next 30 years, resulting in a real yield of 2.3% for the EDV. This is likely to be significantly higher than real GDP growth. Real GDP growth has averaged 2% over the past decade and more than half of this has been driven by rising employment, with output per worker slowing to below 1%. With the unemployment rate near recent lows, future growth is likely to be capped at around 1% over the long term, suggesting nominal GDP growth of just 3.4%.
An Equity Market Decline Would Allow Real Yields To Fall
If nominal yields were to fall to 3.4% in line with this nominal GDP growth outlook (reflecting 1% real growth and 2.4% average inflation), this would result in over 30% upside for the EDV. The key question is what will trigger a reversal in monetary policy that would cause long-term yields to fall and the EDV to rise.
The widening fiscal deficit is keeping inflation elevated for now, forcing the Fed to drive real bond yields in an attempt to curtail private sector spending. This is a classic case of the government crowding out the private sector, and last week's hawkish Fed meeting appears to have taken the wind out of the sails of risk assets. High duration sectors like technology have underperformed since, while credit spreads have risen, and if this continues it will not be long before policymakers shift their focus towards easing to prevent a recession.
There is a growing risk that falling risk assets trigger a flight to liquidity, with investors dumping risk assets in favor of dollars, driving down inflation expectations. The current macroeconomic picture looks similar to that which prevailed in mid-2007. A spike in bond yields pricked the global equity market bubble, allowing both inflation expectations and real bond yields to fall, leading to a collapse in long-term bond yields.
Rising Bond Supply Is A Long-Term Risk But YCC The Likely Response
The main reason to avoid long-duration Treasuries is the ongoing rise in government debt. Public debt has risen at an annualized rate of 7% over the past 3 years even as Covid stimulus measures have been wound down, and it is likely to accelerate amid the rise in welfare spending amid rising immigration and an ageing population. This would require the Fed to maintain high interest rates to control private sector spending, undermining the EDV.
As interest costs threaten to rise exponentially due to the combination of rising bond yields and high government debt, fiscal deficits could balloon, creating political pressure for spending cuts to avoid a loss of faith in the dollar as a store of value at home and abroad. After all, rising bond yields are a signal to those in debt to reduce spending, which is why rising yields are said to be the cure for rising yields. Even if spending cuts prove too politically unpopular, this may not necessarily lead to rising bond yields as the Fed may be forced to follow in the footsteps of the Bank of Japan and cap bond yields below market levels. While such a move would be negative for the dollar it would still likely benefit the EDV in dollar terms.
For further details see:
EDV: The Case For Long Duration Bonds Is Strengthening Despite Surging Supply (Rating Upgrade)