(Bloomberg) -- Once again, the fate of the long-standing bull market in U.S. Treasuries hangs in the balance.
Last week, bond yields briefly broke above 3 percent for the first time since 2014 and prominent investors like Paul Tudor Jones and Ray Dalio say a full-on bear market is all but inevitable this time as rates rise and deficits grow. The die-hard bulls predictably insist the doomsaying will once again end in tears.
But in a debate contested over “psychologically important” levels and “make-or-break” moments, both sides are missing one key point: The remarkable, three-decade-long bull run pretty much ended years ago.
Truth is, returns on U.S. government bonds have been so lousy they’ve failed to keep up with even the stubbornly weak inflation we’ve seen in recent years. On average, Treasuries have returned just 1.4 percent a year since the end of 2014, less than the 1.64 percent annual increase in consumer prices, data compiled by Bloomberg show. In other words, people have been losing money after taking inflation into account.
And that hasn’t happened since Treasuries were in the final throes of the last multi-year bear market, during a three-year span that ended in 1981.
“A market for which you are not making money does not meet my simple definition of a bull market,” said Michael Shaoul, the head of Marketfield Asset Management. “All these guys that talk about the end of the bull market and when the bear market will start are failing to adjust to the point that you are not actually making money today and you haven’t for several years.”
That’s saying something, considering just how entrenched the bull case for bonds has been during the post-crisis era. (See here, here and here.) Now, with inflation on the upswing, the sobering reality is that so-called real returns on Treasuries -- which is what investors actually take home after accounting for the cost of living -- might get worse before they get better.
Of course, Treasuries aren’t supposed to lose money. The whole point is that they’re safe assets that provide a fixed rate of return and protect against inflation. Negative real returns are a legacy of the Federal Reserve’s extraordinary stimulus, or quantitative easing. Not only did QE -- which resulted in near-zero interest rates and trillions of dollars of debt purchases -- push Treasury yields to record lows, but it kept them there for years.
You can also argue that QE created an environment where market watchers have become overwhelmingly focused on yield levels and the direction of every fluctuation, however small. Often times, it can seem a bit arbitrary.
In addition to calls by Tudor Jones and Dalio, some big-name investors like Scott Minerd of Guggenheim Partners have zeroed in on 3 percent for 10-year Treasuries as a bear-market threshold, while others have called it a buying opportunity. There were times in the past year when 2.6 percent and 2.4 percent were hyped as the key levels to watch. And don’t forget that Bill Gross declared a bear market as yields crossed 2.5 percent in January, after years of supporting the “lower for longer” bull case for Treasuries.
Part of the problem is that, unlike stocks, there’s little agreement over what actually constitutes a bear market. As long as the U.S. doesn’t default, you’ll get your money back and earn a nominal return, so the 20 percent price drop that would trigger a bear market in equities really doesn’t apply. And while most observers associate persistently low yields with strong demand, that doesn’t necessarily equate to strong returns.
“I don’t think investors are saying I’m investing in fixed income to lose money,” said Mark MacQueen of Sage Advisory Services. “They are investing in fixed income to diversify their portfolio and lower market volatility.”
But what’s clear is that, over the past three years, Treasuries have been a losing proposition. Using the Bloomberg Barclays U.S. Treasury Index as a proxy, they’ve lost an average 0.24 percent versus inflation on an annualized basis. And over the first three months of this year, things have only gotten worse, with the benchmark down 2.41 percent in real terms.
That might not seem like much compared with the losses during the prolonged and nasty bear market in the late 1970s, but it doesn’t take much when yields are so low. Although Treasuries have lagged behind inflation any number of times in a single year, prior to the most recent three-year span, there hasn’t been such a sustained period of weakness since the modern bull market began in 1982. The pattern largely holds true for 10-year notes as well.
To make matters worse, Treasuries have become more prone to losses because the scant interest they pay provides little cushion against price declines. Currently, over $800 billion of Treasuries with at least five years to maturity carry coupons of 2 percent or less, data compiled by Bloomberg show. Almost all were issued in the past three years.
“It’s not surprising you have slightly negative returns on high-quality, fixed income even as inflation has been low but creeping up a little bit,” said Gene Tannuzzo, a money manager at Columbia Threadneedle Investments. “But people had been feeling for a while that they wanted a reset to a positive real yield, and with the 10-year’s rise this year we’ve had that.”
To be fair, it’s entirely possible Treasuries could rally just like in 2014 -- whether it’s a trade war, geopolitical shocks or a sudden downturn in the economy -- and reward traders nimble enough to time the market. And longtime bulls often cite that year as a cautionary tale for anyone foolish enough to bet against the bond market. What’s more, real 10-year yields are back above zero, suggesting the risk-reward for current investors is better than in previous years.
But for longer-term investors, it’s worth noting the stunning gains in 2014 were barely enough to recoup 2013’s staggering losses (and arguably possible only because of the surge in yields the previous year). Going back to 2 percent yields could leave the market vulnerable to losses versus inflation yet again.
Margin of Safety
And these days, all signs suggest inflation is picking up. With the Trump administration’s tax cuts fueling an already strong economy and adding to wage pressures, analysts see consumer prices rising 2.5 percent in 2018 -- the most in seven years. That could push the Fed into at least three quarter-point rate increases this year, and put Treasuries under additional pressure. U.S. is also expected to add a lot more debt supply in coming years as deficits are projected to surpass $1 trillion by 2020.
At the end of the day, a selloff that resets Treasury yields to higher levels on a permanent basis might ultimately be the best thing for longer-term investors, despite the short-term pain.
“We are going to move from historically low real -- after inflation -- returns back to something that is halfway between history and where we spent the last few years,” said Scott Mather, Pimco’s chief investment officer for core strategies. “This means bonds will be more attractive to people, especially to those that want less volatility with their savings.”
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