In the 2010 decade there have been three distinct business cycles based on several indicators such as growth in manufacturing employment, heavy truck sales, credit spreads, or purchasing managers surveys. The three cycles spanned 2009-2013, 2013-2016, and 2016-2020.
Their pattern is important because they had an impact on several asset prices. The last business cycle – the one going from 2016 to 2020 – provides, for instance, imported lessons on how long-dated Treasury yields behave.
Some investors focus on the direction of the economy. Is it going up or down? What happened between 2016 and 2020 should help to recognize the power of small changes in the growth of business activity on investment timing.
In 2019 Wall Street agreed the economy was expanding and bond prices were extremely overbought. Yields had to move higher and prices lower. Several major strategists embraced this view.
Wall Street did not recognize business activity was already in the midst of a slowdown which started in mid-2018. Yields on 10-year Treasury bonds had bottomed in 2016 at around 1.4% and then rose until they peaked at 3.0% in 2018 as growth in business activity was rising. They began to decline in 2018 as the economy slowed down to finish at about 1.4% in 2019.
These levels were excessively low – or so Wall Street kept saying at that time. They could not go much lower given the economic expansion. Analysts repeated bonds were overbought and yields had to rise because the economy was still growing and the easy monetary policy of the Fed implied only one outcome – rising inflation.
Of course, rising inflation would have been the kiss of death for bonds. Hence the conclusion yields had only one way to go – sharply higher. Instead yields kept trading around 1.4% (pre-pandemic) to fall well below 1.0% (post-pandemic.)
What did go wrong with the forecasts?
The first wrong assumption was that large levels of debt accompanied by easy monetary policy was going to be inflationary. It did not happen. It may, but not as of this writing.
The second assumption was growth is associated with higher yields. What was not recognized was the economy was growing but it was slowing down. This is an important fine point but it is crucial to assess the trend of long-term Treasury bond yields during a business cycle.
Market prices are an extremely sensitive mechanism. They do not react to expansion or contraction. They are much more sensitive than that. They move based on changes in business activity.
Yields started to decline in 2018 because the economy began to slow down. They stopped to decline when the economy strengthened again in March 2020.
Where do we go from here? The financial stimulus coming from Washington is supposedly aimed at strengthening the economy. The economic increase has been taking place since March. Business was not waiting for the stimulus from Washington. Housing, durable goods orders, and manufacturing output have been spiking. Replenishing depleted inventory has been a major trigger for manufacturing and the new business cycle.
As soon as the next business cycle kicked in in March 2020, yields stopped declining and moved higher. This is exactly what was supposed to happen. As long as growth is improving, yields are more likely to rise than to decline. They will decline when growth subsides again.
In the near-term, the decline in credit spreads suggests business activity still has solid tailwinds. The investment implications? Long-term Treasury bond yields cannot decline when the business cycle is on an upswing as shown in the previous charts.
From an investment viewpoint bonds (TLT) have the purpose of stabilizing the volatility of an equity portfolio. Despite the low level of yields, TLT is an attractive hedge as shown by its price pattern when the equity market has sharp moves.
For instance, on 10/5/20 SPY rose +1.77% and TLT sank -1.95%. On September 21, SPY declined -1.11% and TLT rose +0.51%. This price pattern is making TLT an attractive and safe hedge when the business cycle turns down.
This hedging feature is further enhanced if investors follow the trend of the business cycle and reduce their bond exposure when the business cycle rises and increase it when the business cycle declines.
Disclosure: I am/we are long TLT.