Capitulation

It is not often that followers of the all-too-staid bond markets get to use the word capitulation. Usually things don’t move fast enough (or far enough) to warrant the use of the word. We, however, having declared the end of a three decades long trend, see a significant change taking place.

We marked late 2012 as the end of the bull market in Bonds, though the hockey-stick final mania in the longest maturing bonds didn’t occur until last spring, culminating July 6, 2016. Shorter term bond yields had risen since 2012 while the 10 year US Treasury bottomed at 1.32%, a significant turning point in trend.

The second half of 2016 saw yields spike to 2.64%, such that by year-end (December 2016 Letter) we called for a correction of this first move in the long-term bear market for long-term bonds. Indeed yields moderated back down to 2.13% early in June. So far so good and right along our projected path.

Which brings us to today. Actually it was a June 9^th Bloomberg headline that used Capitulation, saying “Investors betting on rising bond yields just threw in the towel in a big way, according to Bank of America.” Citing the “biggest inflows to bonds in well over two years”, BofA concluded the performance of credit equities are “highly correlated.”

I am heartened that there are such animals as Bond Bears roaming the earth. Whether or not they threw in the towel as interest rates have moved lower against them this year is conjecture at best. But I like the use of the word Capitulation as large bets that interest rates will continue their decades long decline is usually just what is needed as markets reverse trend.

Another indicator of capitulation may also be the steady drumbeat higher of municipal bond prices relative to their US Treasury counterparts.  According to Bloomberg, ten year municipal bond yields are now 83% of treasuries which is the richest level since the financial crisis began in 2008.  Take a look at the Pearland TX ISD bond yields below from a deal that sold last week.  The noncallable serials are all priced below 2%, all the way out to nine years.  Such high prices and low yields along with high current demand just may make this a capitulation point for municipals.

We believed rates would move higher from their July 2016 low (they did) and that they would move lower from their December 2016 high (they did). Now, grabbing hold of Bloomberg’s headline of a BofA paper, we believe the correction reached a level of Capitulation.

We see higher long-term interest rates from here. Not just a little, but a lot. For the past several years we have seen lots of long-term bonds issued with coupons of 2-3%. It doesn’t take a significant move higher in interest rates to destroy significant value in these bonds. I am looking for a more than significant move.

Trend reversals don’t happen often. Whether you use 2012 or 2016 as the trend change date, this is the first overall trend change in three decades. As we have seen over the past year, interest rates also do not move in a straight line. They move, correct and now, after a capitulation, they are set to move again (higher).

This letter was written prior to the next Federal Reserve interest rate decision on June 14^th. What the Fed does, or doesn’t do, is irrelevant to my forecast: we see significantly higher long-term interest rates from here.

The other significant details in Bloomberg’s BofA article was to highlight the performance of credit (Bonds) and equities (Stocks) are “highly correlated”. As we have been saying for months now, the hockey-stick mania we forecasted last summer for stocks (August 2016 Letter) has certainly come to pass. As Bonds turn and Stocks peak it will be profitable to remember that Stocks and Bonds are correlated.