Here’s a strange thought from Jeff Gundlach, one of the world’s largest bond managers:
“If you get above 3%, then it’s truly, truly game over for the ancient bond rally.”
And here’s Bill Gross from earlier this month:
Gross: Bond bear market confirmed today. 25 year long-term trendlines broken in 5yr and 10yr maturity Treasuries.
— Janus Henderson U.S. (@JHIAdvisorsUS) January 9, 2018
This is super interesting. In essence, two of the world’s most famous bond managers are making massive secular bond calls based on…lines on a chart?
This raises a couple of important questions: 1) what is this theory of inflation? And; 2) does inflation (and therefore bond prices display long-term momentum? These are big questions so let’s think about this some more.
Now, the interesting thing about using charts to read the bond market tea leaves is that it implies that interest rates are primarily a momentum phenomenon. In other words, when interest rates break X% then there’s a probability that they will continue higher or lower. As I’ve noted before, momentum works in an equity market index fund for fundamental reasons – the fund is essentially a rules-based product that sells losers and buys winners thereby attaching itself to long-term growth in corporate profits. But should momentum work in the bond market?
What Drives Bond Prices?
First, let’s look at a simple example of stocks and bonds. Stocks have momentum in the sense that corporate profits are generally rising. An equity instrument is attached to that stream of increasing income. An equity index fund is a rules based system that always maintains exposure to this growing pie of income. Therefore, it exhibits momentum.
A bond is an instrument with a fixed income stream. A high-quality bond exhibits momentum for the same basic reason that the equity market index fund does – it has little risk of permanent loss because the instrument is designed not to expose the investor to credit risk. So, the equity market index fund sheds losers before they become losers and the high-quality bond is an inherently safe instrument with low principal risk. But when we analyze bond returns and the risk of owning bonds at current rates we aren’t trying to analyze whether that bond will have momentum. We really want to know if interest rates have momentum because we want to analyze the real opportunity cost of buying bonds today versus buying bonds later.
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