Bonds May Be the Single Most Overvalued Asset Class

Bonds May Be the Single Most Overvalued Asset Class
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*     Bonds may represent one of the most expensive asset classes extant

*      Barring a recession, bond holders are almost guaranteed losses over the next decade

On both stocks and bonds, I am at the polar opposite of Mae West who once said,"Personally, I like two types of men, domestic and foreign."

As overvalued as I believe the the U.S. stock market may be, fixed-income instruments may be even more overvalued.

After being stuck in a range of between 2.30% to 2.65%, the yield on the 10-year U.S. note breached the lower end and ended last week at 2.23%.

Yesterday the 10-year note was yielding 2.21% -- the lowest yield since last Nov. 11 -- and the long bond's yield is down to 2.88% after weak core consumer price index (CPI) and retail sales were released on Good Friday, when the markets were closed.

This decline in yield and rise in bond prices may be the last opportunity for a generation to sell fixed-income positions. Indeed, bonds may now represent the single most overvalued asset class extant.

Among other issues, signs of rising geopolitical risk, moderating domestic economic growth and a slippage in the Trump fiscal agenda have taken the yield on the 10-year U.S. note down by 40 basis points from the recent high in yields.

This rise in bond prices and decline in yields is providing a significant opportunity to sell any and all fixed-income holdings before it is too late. Short of an economic recession, bond holders are almost guaranteed bigly losses over the next decade as we are now set on a likely path to lower bond prices and higher bond yields.

Here is my investment rationale:

*      History Rhymes: The 10-year U.S. note yield measured against a reasonable forecast for nominal GDP is totally out of whack with its historic relationship. Over the last five decades, the relationship between yield and nominal GPD has averaged 1.0x. During those years, the average yield on the 10-year U.S. note has been about 5.65% -- exactly the same as nominal U.S. GDP. Looking forward, if nominal GDP (real GDP plus Inflation) is expected to average about 4%, the 10-year U.S. note yield also should be 4% if that historical relationship of 1.0x held. Today, the 10-year U.S. note yield stands at 2.21%, or only 0.55x the projected nominal GDP.

*       The 10-Year Note Yield Is Far Too Low and the Price Is Far Too High: The causes of lower interest rates are multiple -- e.g., non-U.S. rates and low fed funds "anchor" our low yields. But with inflation likely to increase at about a 2.25% rate and real GDP to conservatively average only approximately 1.75%, assuming a relationship of even 0.75x (down from 1.0x) produces an intrinsic 10-year U.S. bond yield of 3.00%, or nearly 80 basis points above today's yield.

*       Trump Fiscal Policy Is Down But Not Out: The Trump regulatory, tax, repatriation and infrastructure agenda have been pushed back, but that doesn't mean they have been abandoned. Indeed, a shifting and more centrist Trump who has reneged on many of his more extreme campaign promises may have a smoother and better chance of seeing his fiscal policies enacted in the months ahead.

*     Trump Is Talking Down the U.S. Dollar: The president is now endorsing a weak currency. Foreigners are already net sellers in size of U.S. treasuries; Trump's weak dollar protests may result in the inclination for those non-U.S. sales to accelerate over the next few years. In addition, a weaker U.S. dollar could have adverse inflationary consequences and put more pressure on higher rates.

*      The Hard and Soft Economic Data Likely Will Begin to Converge Slowly in the Months Ahead: While I remain an economic skeptic, the wide extreme between hard data and soft data should begin to converge somewhat, with the hard (real economy) data starting to move up a bit while the soft data (confidence, etc.) should turn down moderately:

*      The Flexing of U.S. Military Strength May Work: The flight-to-safety trade -- a byproduct of rising political and geopolitical risks -- may be in the process of peaking as the world stage becomes convinced that while Trump's military initiatives have made headlines, they may not be as dangerous as many believe and will not likely result in major conflicts in North Korea, Syria and elsewhere.

*      The Fed Likely Will Maintain a Steady Hand: A regular increase in fed funds hikes coupled with a balance sheet reduction by the Fed.

*      Europe's Political Status May Settle Down: The European elections, particularly that of France, may not be as disruptive as generally thought.

*      Speculative Shorts Are Reduced: The short bond market positioning has been reduced in the recent drop in the 10-year U.S. note from 2.60% to 2.21%. The large Treasury bond short position has dwindled as more than 500,000 contracts have been covered, leaving the speculative shorts back to pre-November 2016 levels.

Here are my five key investment conclusions:

*      I continue to believe, as I projected last July, that we have seen a Generational Bottom in Bond Yields.

*      Bond holders are today almost guaranteed losses unless we have an economic recession.

*      Even though the trajectory of domestic economic growth likely will disappoint relative to consensus expectations, our economy likely will grow moderately and inflation will also advance.

*      I expect a slow but steady rise in bond yields over the next five years. Over the next three months I expect the yield on the 10-year U.S. note to move back into the 2.30% to 2.65% range. I expect the 10-year U.S. note yield to be close to 3.0% in the next nine months

*      Sell bonds, post haste!

Most importantly, never forget that in your own analysis of the fixed-income markets:

"Its better to be looked over than overlooked!"
--Mae West

Doug Kass is president of Seabreeze Partners Management Inc. This essay originally appeared at  

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