As you know, the price of a bond is inversely correlated with interest rates. As interest rates go up, the price of a bond goes down. This makes sense.
If the face value of a bond is $10,000, and the interest rate paid by the bond is 10% of the face value, the bond pays $1,000 per year.
If market interest rates drop to 5%, and a new bond is issued with an interest rate of 5%, to earn that same $1,000 in interest, an investor would have to buy $20,000 worth of bonds.
But I own this bond with a fixed coupon of $1,000 per year. What will you pay me for it? The same $20,000. Interest rates dropped, so my bond is now worth more.
For the last year, interest rates have been going up:
The US Government 2 Year Bond yield was 0.44% on November 30, 2021, and a year later, on November 26, 2022, it’s at 4.467%.
That’s an increase of 10X, but that’s not my point. Here’s my point:
The Ishares 20+ Year Treasure Bond ETF, ticker symbol TLT on the Nasdaq, peaked at $154.91 on December 3, 2021, and collapsed down to $91.74 on October 24, 2022.
That’s a drop of over 40% in less than a year for a “safe, conservative” investment. Wow.
But this is exactly as we would expect. Interest rates went up, bonds are inversely correlated, so bonds went down.
Now for the important question: what’s next for interest rates?
If interest rates continue to increase, bonds will continue to drop. But, if interest rates have peaked or are close to peaking, bonds will start to run to the upside.
As the two charts above show, although interest rates have continued to increase, TLT stopped dropping in October and appears to have turned upwards. Why?
The obvious answer is that investors are forward-looking, so while interest rates are going up today, they expect that by tomorrow, next month, or next year, interest rates will turn lower, so now is the time to buy bonds to get in early.
Why Would Interest Rates Go Down?
Why did they go up? Inflation. Or, more specifically, central banks are raising interest rates to slow down the economy, to reduce inflation. Inflation is still “running hot,” so interest rates are rising.
I can’t predict the future, but my guess is that the Federal Reserve will raise interest rates again at their meeting in the middle of December. I also predict that a recession will be officially declared around March 2023. Once we are obviously in a recession, the economy no longer requires cooling, so interest rate hikes will pause. If the recession is severe, the Fed will lower interest rates to stimulate the economy, and the up and down cycle will continue.
So what’s your bet for 2023? Will we avoid a recession? If so, inflation will remain high, interest rates will stay high, so bonds will not be a good investment.
If that’s your opinion, the market disagrees with you, as clearly observed in the TLT chart. The market believes interest rates are peaking, and bonds will be the investment of 2023.
I agree.
The only question is: do I buy now, or wait until after the final Fed increase of the year in December?
The answer is to start accumulating a position now.
Everyone agrees that the Fed will raise rates in December, but their messaging will be more important. Do they say “we will continue to raise as long as inflation is increasing?” If so, at the first sign of inflation not increasing as fast, the market will expect lower interest rates in the future, and bonds will be the go-to investment of 2023.
TLT could be a great investment.
My plan is to dollar cost average in now, buying 20% of my desired position every week for the next five weeks. If there is a temporary drop at the next interest rate increase, great. If not, I keep buying.
If my average cost to buy TLT is under $110, and in a year TLT returns to $150, that’s a 36% profit. Not bad for a conservative investment.
But wait, there’s more! TLT pays a monthly dividend (a distribution of the interest earned on the bonds in the fund). On November 7, TLT paid .236 per share, so with TLT trading at $102.90 that’s an annual dividend rate of over 2.7%. If interest rates remain stable you earn the interest. If they fall, you get a capital gain.
This sounds like an excellent investment for the conservative portion of your portfolio. Do what you wish with this knowledge.
Thanks for reading; see you next week.
Bonds, Bitcoin, and the Big Picture
by JDH on December 3, 2022
Bonds
Last week I asked a simple question: Is it Time to Buy Bonds? I offered the opinion that as the fact that we are in a recession becomes obvious, the Fed will reduce the rate of interest rate increases, and then pause, and then begin to reduce interest rates. As I said last week:
It would appear that I was correct (at least for now). My preferred vehicle for buying bonds is the Ishares 20+ Year Treasure Bond ETF, ticker symbol TLT on the Nasdaq. Here’s TLT’s chart since my post last week:
Nice little uptick, eh?
I am not good enough to time the bottom, but I did open my position at $103.30, so that was a good start. But now what?
The Fed meets again on December 13 and 14th. The U.S. employment report was stronger than expected this past week. (Yes, I know, employment is a lagging indicator, so employment is not a great metric to watch, but the Fed does, so it influences their decision-making). Inflation remains high, so a 50 basis point increase is virtually guaranteed. The question is, what words does Chairman Powell use to describe the future? If he sounds tough and signals more interest rate increases, bonds could drop from here.
My strategy is to buy 20% of my expected position in TLT weekly over a five-week period. If the market believes interest rates will fall in the future TLT will continue to rise. If not, it falls. So, by the new year, I’ll have my position, and I’ll sit and hold it (and collect the dividend each month, currently yielding around 2.5% per year).
Bitcoin
As I write this early Saturday morning, Bitcoin has recovered this week, up around 4.5% over the last seven days. On a longer view, Bitcoin remains in an obvious downtrend.
Prior resistance levels have fallen. The next stop down could be just under $14,000, around the prior cycle peak in June 2019. $12,207 is the resistance level below that.
Bitcoin is currently down around 75% from its all-time high in November 2021. A review of the prior Bitcoin bull market is instructive. From the peak in June 2019 Bitcoin dropped 54% and then had a big bounce:
But that bounce was short-lived. Covid happened, and Bitcoin collapsed.
The drop from the peak to the bottom was around 72%.
So is this the bottom? Is 75% it? Perhaps, but I’m not putting any money into Bitcoin just yet. I currently hold no Bitcoin.
If you held Bitcoin this year, you are down a lot. The prudent strategy would be to sell your Bitcoin now, take the tax loss, and buy it back later.
Here’s the key tax planning point: If you sell a stock at a loss and then repurchase it the next day, you can’t deduct the loss for tax purposes. You have a “superficial loss.” Someone will correct me if I’m wrong, but I believe the rule in Canada (with similar rules in the USA) is that you have to wait over 30 days to repurchase the stock to be able to deduct the capital loss.
But Bitcoin is not a stock. Even the SEC agrees that Bitcoin is a commodity, not a security. (Every other crypto is a security due to the Howey Test). So, you can sell Bitcoin on Monday, repurchase it on Tuesday, and deduct the loss.
Now that we are in tax loss season, I assume many investors will sell their Bitcoin and then move to the sidelines, temporarily, to decide when to repurchase. That likely keeps Bitcoin’s price low.
I plan to consider buying Bitcoin for around USD 12,000. Whether or not it gets there, we shall see.
The Big Picture
The employment report last week was brutal. Yes, I know, everyone was happy that non-farm payrolls were up 263,000 in November, higher than the consensus estimate of 200,000. But, the number of hours worked each week dropped by 0.3%, down to 34.4 hours per week, the lowest hours worked per week since the pandemic lows in April 2020. If you multiply the hours worked by the number of workers, that drop in hours equates to a loss of 380,000 jobs!
Think about it: is there a difference between 100 workers working 40 hours per week or 34.4 hours per week? Under either scenario, the unemployment rate is the same because the same number of workers are working. Still, if each worker works less, that is less productive for the entire economy.
So, don’t celebrate the jobs number, because it was a lot worse than it appears.
Let’s not forget that unemployment is a lagging indicator. As the economy weakens, employers don’t immediately lay off workers. They keep them, because hiring and training employees takes time, and employers don’t want to be caught short if they need to increase hiring. It is only after the slowdown becomes obvious that employers start layoffs.
Unemployment (and labour costs) are lagging indicators.
Payrolls, at best, are coincident indicators.
The workweek is a leading indicator. It shows what’s really happening, so that’s the indicator to watch. (Year-to-date the number of hours worked has declined at an annual rate of 1.25%, a decline rate last hit in the summer of 2009).
Let us not forget that there are two employment surveys: the Household survey, and the Establishment survey.
The Establishment survey is a survey of employers: “how many people work for you?”
The Household survey is a survey of households: “do you have a job?”
If times are tight and I’m working two jobs, the Establishment survey will report two jobs, but the Household survey counts people, so one person equals one in the survey.
As the economy weakens and people are forced to take on extra jobs, the Establishment survey will overstate employment. It’s the Household survey that is more accurate.
Here’s the point: the Household survey of employment is way down: a drop of 328,000 in October and 138,000 in November. The last time we saw numbers that bad was during the lockdowns of 2020.
These data points lead me to believe that a recession will be officially declared around March 2023, and that may mark the bottom for the stock market and Bitcoin. Bonds have likely already bottomed.
Do with that knowledge what you will.
Thanks for reading. See you next week.