Torsten Asmus
The iShares 10-20 Year Treasury Bond ETF (NYSEARCA:TLH) is a duration bet, which continues to be a dubious one to make. All the data, as it had before, continues to point to the best-case scenario for TLH of a higher for longer environment, if not an even higher interest rate environment with the possibility of further hikes. Real yields and nominal yields will need to continue to rise, and we think that the transmission of higher rates into the economy will only happen beginning in 2024 with its effect on corporate earnings through higher refinancing rates as debt walls are hit. It's possible it takes till 2025, in our non-consensus view, when the brunt of refinancing will happen across the economy.
TLH Key Facts
What you need to know about TLH is that it has around a 13-year effective duration and a pretty low expense ratio at 0.15% typical of these efficient bond ETFs from iShares. These are Treasuries underlying the ETF, so in principle, no credit risk. It is a great speculative duration factor for a portfolio, and a good instrument to take a highly sensitive bet on rates. However, as we'll elaborate, now is not the time to go long duration.
Immediate Speculative Considerations
The first reason to avoid duration is that data will likely continue to trounce expectations of a Goldilocks economy. In particular, while CPI data demonstrates the issues of inflation, employment data is a leading indicator that continues to point to high persistent rates.
For the Fed, it is essential that rates come down to 2%. This means expectations of inflation must come down to 2% as well. The longer inflation is higher, the more anchored expectations will be at higher levels. This is dangerous. To break the back of inflation, the job market must cool. It is the most important factor for persisting inflation into the next period through the wage price spiral. If there is slack in the job market, inflation is more likely to peter out even somewhat on its own as this important mechanism is weakened. The issue is that the job market remains tight, which essentially requires higher rates or at least high for longer rates in order to start impacting CAPEX, employment, and fundamental economic indicators such that they move in a recessionary direction to contain inflation. In order to cause quicker effects before expectations anchor, the Fed reserves the option to conduct even further rate hikes. We think further rate hikes are more likely than not and have been saying that for the past month.
Timelines
We think that the impact of higher rates on consumers and businesses is somewhat limited, in particular through mortgage rates as mortgages are often fixed, and households have essentially gone short duration by being leveraged in the housing market since before and during COVID-19. This great ‘trade' by households is creating a resilient consumer.
Businesses and corporate earnings are likely where the rates will have a more important impact in beginning to introduce recessionary forces into the economy and start driving down rates. However, this starts principally in 2024 and will come to a head in 2025 and beyond, as this is the timing of major maturity walls for corporate American debt. In particular, the proportion of maturities in the US economy beginning to skew towards unprofitable and lower credit risk firms as the years go by, with B-rated and other junk-rated bonds growing in the mix substantially in 2024 and 2025 in particular.
Current rates will be sufficient to drive substantial increases in interest expenses for corporate America in 2024, but the Fed may raise rates again before 2024 starts. Higher interest expenses and lower corporate earnings will surely be met with a wave of restructuring efforts to preserve profits, including measures to reduce employment. Moreover, lower CAPEX, as we've already seen in businesses like biotech, will start impacting industrial profits which are more cyclical and have higher operating leverage as well. Earnings declines will be the indicator that should correlate with real recessionary hits that will help contain the current velocity of inflation and start driving it down.
Bottom Line
Long-term rate expectations have been rising. This is what is principally damaging for long-duration bonds' valuations. Deglobalisation and other long-term inflationary factors are a limit to how much rates can turn. While we think the yield curve is becoming more realistic now, there is still scope for higher long-term rate expectations especially as we risk coming down from a higher short-term peak than expected. Rates are likely to start coming down gradually once corporate earnings take a more major hit and when bankruptcies really start to rise with excessive burden in the junk bond space on corporates. But until companies feel the need to respond with en masse firing and total hiring freezes, we are unlikely to see the end of higher rates and speculation of higher rates, and with still a difference between possible short-term rates and where the yield curve currently lies, there continues to be downside.