Bond Markets – Sherlock enters

Referring to himself as a “consulting detective”, Holmes is known for his skills in observation, deduction, forensic science and logical reasoning bordering on the fantastic, which he uses when investigating cases for a wide variety of clients and reasons.

“Discovery is, or ought to be, an exact science, and must be treated in the same cold and unemotional manner. When you have eliminated the impossible, whatever remains, however improbable, must be the truth.”

– Sir Arthur Conan Doyle

So today, I use his methods to look at the bond markets and investigate what’s going on and where we are now. The general thinking and the thinking of the Fed, in my opinion, does not seem to be helping either the US economy or the investors riding their coattails, and so, I bring one of the greatest deductive minds to the investigation.

The Bloomberg Treasury Index now stands at a yield of 4.446%, with the Fed pushing inflation and trying to get us down to their benchmark of 2.00%. Therefore, the Treasury Index is roughly 245 basis points higher than the Fed’s desired inflation number, which raises many questions about the accuracy of the spread and what will happen to Treasuries if the Fed ever hits their target. This is something to think about.

“Holmes and Watson are on a camping trip. In the middle of the night, Holmes wakes up and gives Dr. Watson a push. “Watson,” he says, “look up in the sky and tell me what you see.” “I see millions of stars, Holmes,” says Watson. “And what do you conclude from that, Watson?” Watson thought for a moment. “Well,” he says, “astronomically, it tells me there are millions of galaxies and potentially billions of planets. Astrologically, I note that Saturn is in Leo. Horologically, I conclude that it is about a quarter past three. Meteorologically, I suspect that tomorrow we will have a beautiful day. Theologically, I see that God is almighty and we are small and insignificant. Eh, what do you say, Holmes?” “Watson, you idiot! Someone stole our tent!”

– Sir Arthur Conan Doyle

Bloomberg index	productivity	Distributed in Treasuries
IG Corporations	5.336%	88 basis points
High performance corporation	7.915%	347 basis points
Mortgage Index	5.086%	64 basis points
Municipal bond index	3.652%	79 basis points

Click to enlarge

*All data according to Bloomberg on 16.6.2024

So the answer to the first question—where will Treasury yields go if we reach an inflation rate of 2.00%—is downward, with inflation falling sharply from our current levels if the Fed manages to reach its stated target. The yields of all other indices will also fall, but there is a caveat here, which is our current spread.

In my view, spreads in the secondary bond markets are nowhere near, at the moment, reflecting adequate “credit risk”. No one is currently earning enough income to account for “credit risk” when the Fed is trying to lower inflation, which also, at the same time, leads to a slowdown in the US economy. Furthermore, the methods of calculating inflation – the Consumer Price Index (CPI) and the Producer Price Index (PPI) – simply do not adequately reflect the actual inflation that is currently in the US economy. The numbers of both these indices are compounded in such a way that they are incorrect by compounding.

From the Bureau of Labor Statistics (06/12/2024):

“In May, the Consumer Price Index for all Urban Consumers was unchanged, seasonally adjusted, and rose 3.3 percent over the past 12 months, not seasonally adjusted. The index for all items less food and energy increased 0.2 percent in May (SA); up 3.4 percent over the year (NSA).

The producer price index for final demand fell by 0.2 percent in May. Prices for final demand goods fell 0.8 percent, while the index for final demand services remained unchanged. The index for final demand advanced 2.2 percent for the 12 months ended May.”

Again, specifically, and to put it bluntly, bond investors are not currently getting yields that justify either our current “credit risk” or our spreads on Treasuries or the current rate of inflation or the current state of the US economy. Bond investors, in my opinion, not only in these areas, but also in the cost of borrowing, in various other areas, are not being adequately compensated for the risks they are taking. The only place I see actual value, in fixed income, is in some of the exchange-traded funds or closed-end funds, where leverage is used to drive yields up to reasonable levels, some in the double-digit range. There are also “private placements”, of course, but there a large amount of liquidity is lost, given their structure, which is also part of this picture.

So, I repeat it again:

“How often have I told you that when you have eliminated the impossible, whatever remains, however improbable, must be the truth?”

– Sir Arthur Conan Doyle

So today I emphasize to bond investors that returns are not worth the risk, and I believe that my determination should be taken seriously. This is my honest opinion.

Original source: Author

Editor’s note: The bullet points for this article were selected by Alpha’s research editors.