2023-12-19 16:41:52 ET
Summary
- With the new Fed dot plot, I see a 2% cut in interest rates is a possible 2023 black swan event.
- I will analyze the impact of such an event on the iShares 20+ Year Treasury Bond ETF to illustrate the upside potential in treasury bonds.
- I will also use my real money accounts to illustrate how we are positioning our portfolio based on the analysis.
The new dot plot
The FOMC meeting held on December 13 was a significant event for the market. In particular, the new dot plot shows the potential investment opportunities in treasury bonds, as I will illustrate via the iShares 20+ Year Treasury Bond ETF ( TLT ) in the remainder of this article. In case you have not seen the new dot plot below, it is in the chart below. The gist is that The Federal Reserve's latest meeting minutes indicated their members now expect more rate cuts next year than they had previously expected. The new dot plot's median dot now implies that there could be up to three rate cuts by the end of 2024 totaling 0.75% (from the current level of 5.4% to be around 4.25%), followed by more cuts after that (to around ~3.5%) in 2025.
The above scenario really is the ideal soft-landing case in my view, which will of course benefit treasury bonds. Next, I will go a step further and argue why there is a possibility that: A) rates would go down more than 0.75%; and/or B) more quickly (in the case of a hard landing for example).
TLT: basic information
Let me start with a quick intro to the TLT exchange-traded fund, or ETF. To highlight some of its features (and issues), I will do the intro via contrast and comparison against the Vanguard Extended Duration Treasury Index Fund ETF Shares (EDV). Both are extended-duration treasury bond ETFs, as seen from the table below. However, TLT is a much larger fund with assets under management, or AUM, of over $52B. EDV is much smaller with an AUM of $3.6B. On the other hand, EDV charges a much lower expense ratio (0.06%) than TLT (0.15%). I will revisit these features later and elaborate on their implications for your investment styles and goals.
Market's view vs. my view
To better explain the reasons why I see deeper/quicker cuts, let me start with a recap of the market's interpretation of the FOMC meeting minutes . The punchline in my mind is that the Fed now has more confidence in a "soft landing" as mentioned above, a scenario where the economy slows down gradually without causing a recession or a spike in inflation. The confidence is anchored on a few considerations, primarily the inflations and employment outlook. The Fed's new projections imply that the inflation rate could stabilize and then decline closer to its 2% target. The Fed also expected the labor market to remain stable and near full employment. As a result, the market is now anticipating up to three rate cuts by the end of 2024 totaling 0.75%.
However, I see a realistic possibility for larger and/or quicker cuts. First, we need to look at the scatter of the dots. The media (like in the chart above) loves the "median" point. It helps to simplify a complicated matter into one single number. However, I think this is an oversimplification and the scattering of the dots matters as much in my mind. The scattering of the dots for 2024 also spread to as low as 3~4%.
Second, unemployment and recession are the other two key variables in the Federal Reserve's consideration. If the economy shows signs of a recession and/or an uptick in unemployment, the Fed might accelerate rate cuts to stimulate borrowing and spending. I see a realistic chance of both. For the recession, the yield curve has been and remains inverted, which historically served effectively as a leading signal for recession. For unemployment, the current level of unemployment is near the lowest level since the 1950s (see the chart below). Based on historical data, I do not see too much chance for unemployment to stay at this bottom level for too long, or too much room for it to further decrease.
TLT: impacts from potential interest cuts
The price movement of bonds approximately equals the changes in rates times their duration. As seen in the chart below (highlighted in the red box), TLT has an effective duration of around 17.1 years. Therefore, a 0.75% rate cut (the soft-landing case) would cause a price gain of about 13% (17.1*0.75%). In the case of a 2% rate cut, the price gain would be about 34%. On top of the price gain, it would also provide coupons in the meantime, adding more to the total gain.
Risks and final thoughts
Before closing, I want to warn our readers about the risks to my thesis. Besides the generic risks involved in interpreting the dots plot (after all, the Fed never explicitly promised any rate cuts), I want to point out the volatility risks to my thesis. The chart below shows the MOVE index, which is a measure of the volatility of U.S. interest rates. The data was taken from Yahoo Finance . As of this writing, the ICE BofA MOVE index hovered around 125.4 as seen. As seen, this level of MOVE is among the highest levels since 2003.
To me, such a heightened volatility index accentuates the uncertainties facing our current macroeconomy. Especially with longer-duration bonds like those held in TLT, such volatility could be magnified by the effective duration of the ETF and result in large downward price movements.
However, my overall conclusion is that upward risks outweigh the downward risks. To recap, in the case of a soft-landing scenario and rates decrease by 0.75%, which is the market's dominating expectation, TLT would deliver a handsome price return of around 13% plus the coupons. In the case of a hard landing, which I see as a realistic scenario, TLT could deliver far higher returns (up to ~34%) more quickly. As an expression of my thesis, the chart below shows our actual holdings. As seen, we hold a substantial amount of EDV. The majority (64%, nearly two-thirds) of our current bond holdings are toward extended duration rather than intermediate bonds.
The reason we favor EDV over TLT is primarily the fees mentioned earlier (0.06% vs. TLT's 0.15%). We are not traders, and our turnover rates are quite low. So, we do not feel TLT's larger size and tighter trading spread justify the higher cost to us. But otherwise, these two funds are very similar in their fundamental characteristics.
For further details see:
TLT: 2% Rate Cut Is A Possible 2024 Black Swan