Noise is Hiding a Tremendous Bond Market Opportunity

What is noise?

Noise in the markets is the primary determinant of hour-to-hour and day-to-day price changes. While it is very important for short term direction, its influence wanes quickly.

Several competing narratives attempt to explain why bond yields are rising. At first glance, they make a lot of sense and should be worrying. But if you research them, you will find many recent bond-market narratives were insignificant temporary noise.

Noise can be separated into real noise and false narratives.

Real noise

Real noise includes influences that change the demand and or supply of bonds.

For instance, risk (or term) premium describes investors' preferences for longer-maturity bonds versus rolling over a series of short-term bonds. These preferences matter, but trends in the risk premium are well correlated with inflation and inflation expectations. As such, our signal, inflation, catches this noise.

Another example is the Fed. Through managing the Fed funds rate and doing QE or QT, it affects the supply of and demand for bonds. But monetary policy effects will also show up in our inflation signal.

A recent illustration was the flight-to-quality trade to U.S. Treasury bonds due to the Israeli-Hamas war. Likely, the demand spurt will be short-lived as investors acclimatize to the situation. But if the war spreads to Iran or other oil-producing countries, oil-driven inflationary concerns may arise. Again, this will show up in our inflation signal.

False narratives

False narratives are meaningless noise. These are stories pundits tell to justify market actions. False narratives can move markets in the short term, but their shelf life is often minimal.

I exposed a current false narrative in my recent Daily Commentary:

Listening to the media or Twitter, one might think Treasury debt issuance over the last six months is off the charts. Such stories are far from the truth when looked at from the right perspective. Consider the graphs below. The top left graph shows federal debt is growing slightly faster than the pre-pandemic years but well below prior surges. The right chart puts debt growth on a log scale to show the current growth rate is actually slightly below the trend of the last fifty years. Lastly, the bottom graph shows the sharp increase in debt to GDP during the pandemic. However, it has declined since. A high debt-to-GDP ratio, as we have, is very problematic. But false narratives claiming recent issuance is well above average are flat-out wrong.

The recent sell-off in bond prices that drove yields higher is not due to "massive" Treasury debt issuance. Nor is it due to China, Japan, or other nations selling our bonds. The reason is noise.

The signal: Inflation drives yields

The true signal guiding bond yields is inflation. When combined with yield, I have found that a combination of actual inflation data, market-implied breakeven inflation rates, and surveys of inflation expectations are extremely well correlated with yields.

After comparing economic and inflation data with bond yields, I have observed that the Cleveland Fed's Inflation Expectation Index is far and away the best predictor of yields. Per the Cleveland Fed:

How we get our estimates: Our estimates are calculated with a model that uses Treasury yields, inflation data, inflation swaps, and survey-based measures of inflation expectations.

My firm’s fair-value model

The monthly scatter plot below shows that since 1990, 10-year yields and the Cleveland Fed Inflation Expectations Index, which also has a 10-year horizon, have an R-squared of .966. Simply, 97% of the variation in Treasury bond yields is explained by the index. The current yield (green) lies about 1% above the trend line. Ergo, current yields are about 1% above fair value.

Following is a line graph that compares our regression model (dotted line above) to actual yields. They track each with precision. But the green and red differential bars show bond yields can deviate from the model's fair value calculation. As highlighted, the increase in the difference, or noise, has grown since 2008. It is likely due to the Fed's bond-buying activities.

The current deviation is the largest since at least 1990!

Fair-value model predictions

My firm’s fair-value model not only tells us how much noise the bond market is pricing in but also allows us to forecast future fair-value yields based on our inflation-expectations projections.

The regression trend line in the scatter plot (black-dotted line) is defined by the circled formula. It calculates where yields should be based on the Cleveland Fed index.

The slope of the regression line is 2.77x. Each 1% change in inflation expectations should result in a yield change of 2.77% in the same direction.

The current inflation expectation is 2.21%. If you think expectations will eventually return to average pre-pandemic levels (1.65% - 2017-2019), the fair-value, 10-year yield falls to 2.09%. With current yields around 4.60%, a turnaround to fair value would generate a 20%+ return on a 10-year note plus nearly 5% a year in coupon payments.

What if inflation expectations rise?

I have made a bullish case for bonds, assuming the Cleveland Fed Inflation Expectations Index remains at the current level or declines.

I would be remiss if I did not discuss what happens if inflation expectations increase.

If inflation expectations rise by about half a percent, current yields will be at fair value. For every one percent that expectations rise after that, we should expect yields to increase by 2.77%.

Let's put some context around that. Inflation expectations at the recent peak were 2.45% or about .25% above current levels. Therefore, a full 1% increase is highly unlikely, especially given that many supply and demand imbalances that led to higher inflation have largely dissipated.

Further, if inflation expectations start rising consistently, the Fed will increase interest rates and all but assure a recession and disinflation or deflation.

Elevated rental and house prices (a.k.a. shelter) will keep CPI well above where it should be. I say "should be" because real-time market shelter prices are falling. As the arrows in the graph below highlight, shelter should continue to decline, catching up with actual prices. With it, about 40% of CPI will be dragged lower.

Summary

The noise in the bond market is thunderous as inflation is still well above norms, deficits remain high, and the Fed continues to promise higher rates for longer. Noise creates differences between the yield on bonds and their fair value.

Noise is hard to ignore but it can create tremendous opportunities!

Michael Lebowitz is a portfolio manager with RIA Advisors and author for Real Investment Advice. For more information contact him at [email protected] or 301.466.1204.

Income is evolving, is your portfolio? Join industry experts as they dive into fixed income markets and a range of income strategies. Register for our next symposium, October 27 at 11 am ET. Click here.

Read more articles by Michael Lebowitz