Over the last several weeks, global and domestic interest rates have been in free-fall, with the US 10-year Treasury rate nearing 2.0% and the German 10-year interest rate falling to -0.30%.
I have been a vocal bull of Treasury bonds, fighting the consensus opinion that "bonds are expensive," "deficits are too large," "bonds have a bad P/E ratio relative to stocks" and the many other reasons that bond bears have provided as to why rates should rise.
The common thread among these ideas is that they completely ignore the two most important factors that drive sovereign bond yields: growth and inflation. Without a view on the rate of change in growth and inflation, you will constantly be on the wrong side of the trending direction of interest rates.
The past few weeks have seen global interest rates plunge, mainly due to the inflation vector as inflation expectations have been collapsing in Europe and in the United States.
Below we can see a chart of European inflation expectations that have made a new all-time low, falling well below 1.20%.
If we look at US inflation expectations, we can see a similar decline. All else equal, if inflation expectations decline, nominal Treasury yields will decline.
The only way for nominal Treasury rates to rise with declining inflation expectations is for an increase in real interest rates, something that would be historically uncommon during a period of decelerating economic growth.
Back in October of 2018, when interest rates were rising, and the consensus opinion firmly marked the end of the bond bull market, I was on the other side saying not only that interest rates would decline again, but that interest rates would make a new secular low again.
Here is what I wrote back in October 2018 (no paywall) when the 30-year Treasury rate was near 3.40%.
If you buy long-term bonds today, it will prove fruitful as we have not yet seen the secular low in interest rates.
Buying a 3.35% 30-year Treasury with the potential for new secular lows in interest rates over the next several years has enormous profit potential.
I am still a buyer of the long bond.
Since that writing, the 30-year Treasury rate has fallen from 3.35% to 2.54% as of this writing, a greater than 20% gain on the bond in roughly eight months.
Along the way, there were many that claimed each decline in interest rates was the next best opportunity to "short" bonds. Each time, interest rates continued to make a new low.
An analysis provided to members of EPB Macro Research (chart below) shows the average monthly excess performance relative to the S&P 500 for various sectors and asset classes during periods of decelerating inflation expectations.
It is very clear that when inflation expectations are declining, Treasury bonds outperform. (Bank stocks underperform during periods of decelerating inflation expectations which is the only sector we are short at EPB Macro Research since May 2018).
Today, in response to the collapse in inflation expectations, Mario Draghi of the ECB delivered remarks that, of course, opened the door to more stimulus to combat the decline in inflation expectations, leading to yet another decline in global interest rates.
The analysis on which sectors/assets perform well during periods of decelerating inflation expectations is critical but what is even more important for this analysis is a leading indicator of inflation that shows what regime of inflation we are heading towards.
Although it is hard to move the consensus opinion, and when I offered my lead view on inflation many months ago, inflation hawks dismissed the data. Fast forward and inflation expectations have plunged, and bond yields have declined.
Today, the leading indicators of inflation suggest we are going to stay in an environment of decelerating inflation expectations, which means more dovish monetary policy and more than likely, more all-time lows in global bond yields.