TLT: Rebound In Inflation Remains A Threat, Model Says Yields Are Cheap

I perceived a remarkable investment opportunity when long-term yields surpassed 4.5%. I warned last month of a potential significant repricing of bonds as a result of unreasonable rate cuts that had already been priced in. Currently, favorable yields are present, but macro conditions have deteriorated for purchasing due to the following potential threats:

1. Potentially shifting neutral rate as a result of substantial deficits, which propel GDP, and robust readings from economic leading indicators.
2. Inflation trend reversed at the three- and six-month annualized basis for the core CPI and core ex-housing components, respectively.

Although I also cautioned in my previous article, these results are concerning because they resulted in a significant repricing back (rate pricing was just too optimistic). Since the US economy is so robust, higher rates are necessary to curb growth and inflation, which has begun to rise. Conversely, there are significant risks that could quickly halt or even increase the higher-for-longer narrative’s efforts. The first is the growing apprehension regarding CRE, and the second is the neglected problem of securities unrealized losses, which contributed to the failure of a few regional banks by way of a sharply rising yield curve. Should this trend persist, there may be additional risks when the Bank Term Funding Program expires in March. According to my model, there is a long-term opportunity because US10y are somewhat undervalued in relation to market pricing and GDP. But, from a long-term perspective, it makes sense to be long (NASDAQ:TLT) because duration risk is active. Instead, I think it is much preferable to concentrate on (JPST), which offers excellent short-term opportunity due to short-term IG bonds, thereby avoiding volatility and duration risk with great yield.

Market pricing, inflation prints, and the fair value

All inflation prints beat the expectations

The way the market began pricing out the rate cuts at the beginning of the year is shown below. Strong language from J. Powell regarding the FOMC meeting at the end of January was the main driver. Subsequently, there were several noteworthy robust inflation reports, all of which exceeded market expectations, i.e. Headline CPI, Core CPI, PPI, and US Michigan inflation expectations. All inflation prints surprised negatively upwards.

The current market pricing

Following Powell’s statement that there won’t be a rate reduction in March, the market began to revalue the curve. Moreover, it appears that the market is pricing rates to be at 4,6% and 3,9% at the end of 2024 and 2025, respectively, following inflation prints. Put differently, futures suggest that three to four rate cuts will be delivered in 2024, with the first one occurring in June.

The fair value model

I had developed a model (inspired by Jurrien Timmer from Fidelity) that fairly closely tracks the fair value of US10y, based on GDP and Overnight Index Swap. At this moment, the difference is comparable to what it was in 2015, 2016, 2021, or earlier years. Every time, this difference persisted for a few months before returning to a fair value. The outcome of the model is contingent upon market pricing, which is very hard to predict.

But given the price as it stands, we can presume that the difference between the current level of US10y and the model-fitted results—which are frequently regarded as excellent starting points—is largest. Stated differently, the US10y’s fair value is approximately -0.4% less than its current yield of 4,30%. This is a huge benefit since the 10y bond shouldn’t react too sharply because there is already such a large gap, even if implied rates or market expectations rose and reduced rate cuts from the current 3x-4x to only 2-3x. The bond price would decrease, but not by as much as one might anticipate.

A possible inflation comeback and risks to the thesis

The US economy has demonstrated remarkable resilience over the past few months, as evidenced by the services sector’s lack of significant reaction to the tightening cycle in comparison to the manufacturing sector. In my view, one of the key reasons is the massive financial easing that occurred from November to December. The two ISM prints showed an upward surprise.

An extremely risky combination is a robust and resilient economy and rebounding inflation. Even though it might only be one-time event, I think using these combinations will make it difficult for Fed to calm it down. The “Price Paid” Indexes both surprised the market, as you can see below. Even the cost of manufacturing began to rise, but the set of service prices that skyrocketed is concerning. These figures were the first to suggest that the battle against inflation is far from over.

The results of some of the Core CPI components are concerning. Specifically, the 3- and 6-month annualized inflation rates are rising rather than falling, having recently recovered from their lowest points. It simply indicates that returning to the 2% inflation target is not simple. Following a two-month decline to November’s lowest point of 3,06%, the 3-month annualized core CPI rate is now at 3,9% (up from 3,3%) and the 6-month annualized core CPI rate is at 3,56% (up from 3,22% in December). It appears that the trend is just getting started, or to put it another way, it became extremely sticky.

Below you can see some important remarks from FOMC member, Waller about the key inflation elements:

A big factor in the improvement of inflation over the past year has come from goods prices which fell during 2023. Goods prices represent almost 25 percent of core CPI inflation. Even at times of very low inflation, goods deflation is modest in a growing economy, so one question is whether this contribution to progress on inflation will continue. Another big contributor to CPI inflation is the cost of housing services, which measures the estimated costs of renting or the equivalent for owning a home. Housing cost inflation represents about 45 percent of core CPI inflation. But we saw an unexpected jump in housing services inflation in the January CPI data. The remaining component of core CPI inflation is services excluding housing. This category is about 30 percent of the index. Inflation in this category moderated over the course of 2023 but in January there was a broad-based increase.

Examining the data from the Fed’s Mr. Waller essential components, as frequently suggested by Mr. Powell, but on an annualized basis of six months, it appears as follows:

• Core Goods are very well stabilized and do not run inflation pressures.
• Core Services ex Shelter (or let’s say ex. Rent of Shelter) started to bounce-back (upwards) from even elevated levels.
• Core Services ex rent of shelter is increasing dramatically.
• Summing it up, you get Core CPI YoY at 3,87%

Consequently, there have been numerous responses from FOMC members, including J. Powell, in an attempt to pacify markets regarding the initial easing. To be quite honest, I shared the view of many other analysts last year that inflation would be falling quickly, and it was accurate as well. However, I really did not account for the US economy’s strength and resilience, which came primarily from its services sector and low unemployment rate. It helped to the sticky core. From this vantage point, there is a solid likelihood that we will see another round of rate rerating, that is, market implied rates, if the subsequent inflation print reveals another sticky print or even growth as we saw in January’s print. It might therefore only result in one or two rate reductions this year. The bullish narrative of holding long TLT is at risk in this situation (but great fair value is a mitigating factor). One of the main causes of inflation’s comeback, in my opinion, may have been the massive market easing that occurred in November and December. Probably it could be reasonable, because inflation was on good track. Additionally, the rebound in the price indexes as well as the PMI Manufacturing and Services suggests that the US economy may be far more resilient than previously believed. Massive fiscal spending, either in absolute or relative terms, could be the second explanation. Except for COVID years, the deficit surpassed 6% of GDP; it was last observed in 2012.

FOMC’s latest remarks

It is true that certain components, such as the 3- and 6-month annualized rates, reached their lowest point about 1-2 months ago, and in some metrics, it is even 3-4 months ago, even though it is currently difficult to determine whether January’s inflation print is a one-time event, as some FOMC participants pointed out. Thus, it’s doubtful to be a one-time occurrence, but it’s still too early to say for sure. At the end of January, during the most recent FOMC, Mr. Powell made the following statement:

I don’t think it’s likely that the committee will reach a level of confidence by the time of the March meeting.

He was fairly aggressive and made a wise suggestion to reprice the implied rates curve in order to encourage an increase in yields. Here are some of the main FOMC members’ responses—both from hawks and doves—to the January inflation print. Statements are from Bloomberg, FRED and other media sources.

FOMC John Williams:

At some point, I think it will be appropriate to pull back on restrictive monetary policy, likely later this year. But it’s really about reading that data and looking for consistent signs that inflation is not only coming down but is moving towards that 2% longer-run goal.

FOMC Lisa Cook:

I would see an eventual rate cut as adjusting policy to reflect a shifting balance of risks. Inflation has fallen more quickly than anticipated, and the risk of persistently high inflation, though it has not disappeared, appears to have diminished. At some point, as we gain greater confidence that disinflation is ongoing and sustainable, that changing outlook will warrant a change in the policy rate.

FOMC Jefferson:

We always need to keep in mind the danger of easing too much in response to improvements in the inflation picture. Excessive easing can lead to a stalling or reversal in progress in restoring price stability.

FOMC Waller:

Since then, we received data on fourth quarter GDP as well as January data on job growth and consumer product index (CPI) inflation. All three reports came in hotter than expected. GDP growth came in at 3.3 percent, well above forecasts. Jobs grew by 353,000, well over forecasts of less than 200,000, and monthly core CPI inflation came in at 0.4 percent, which was much higher than it had been for the previous six months. Last week’s report on consumer prices in January was a reminder that ongoing progress on inflation is not assured.

Summary & Risks

From this vantage point, things are unclear from a medium-term positioning even though the long-term scenario for being long (TLT) is very promising. Even in cases where inflation is sticky or extremely mild, there is a genuine chance that it will rebound. The Federal Reserve will likely need to exercise extreme caution and patience before deciding to ease policy, which could take another two to three months. In the meantime, the economy is doing quite well, with the exception of CRE issues. It carries only risk. But, for a short-term strategy, holding long position, particularly in the JPST, makes a lot of sense given the wild buying call on the stock market caused by artificial intelligence and the excessive valuation that results from a combination of extremely high expectations that are, on the other hand, coming true. While it has been demonstrated that further rate cuts also depend on medium-term rate expectations and other external factors, further pricing out of rate cuts would likely cause long-term yields to rise. But despite the robust economy and the Fed’s likely preference for a waiting strategy, there is a well-known growing risk in commercial real estate (“CRE”), particularly in the office segment. Even though the cost of offices and their rent has drastically decreased, this decline might be accelerated by a prolonged or consistent period of higher rates. In addition, it matters not only how the Fed will cut but also what is priced in. To put it simply, when implied rates increase, there may be additional pain in the CRE space because higher rates and reduced expectations for rate cuts will not improve the sentiment. The banking system is linked, so when next banks experience margin and profit pressures because of high P&L provisions, it will undoubtedly affect the overall mood and prompt calls for rate cuts because of the increased systematic risk. Regional banks with a high office exposure tend to benefit the most from this. This explains why the current TLT pricing is extremely advantageous over the long run, but may not be so in the short term.

Bill Dudley from Bloomberg wrote some amazing thoughts, which I fully agree with:

Maybe monetary policy isn’t all that tight. That is, maybe the neutral, inflation-adjusted interest rate — the level that neither stimulates nor damps growth — is higher than Fed officials. Large and chronic fiscal deficits, together with public subsidies for green investment, have pushed up the neutral interest rate. If so, the Fed should hold rates higher for longer.

(JPST) offers a 30-day SEC yield of 5,36% and is primarily made up of extremely high-quality corporate bonds, mostly in the index (“IG”) space, with of 65% assets maturing in less than a year and 33% in 1 to 3 years. As a result, duration risks from this ETF are almost entirely eliminated.

From an investment standpoint, TLT is a long-duration ETF that makes more sense if you want to lock in an attractive yield—which is currently near 4.2% to 4.5% —as that is exactly what US20y+ offers. There may be some discomfort in terms of price positioning, but in terms of risk/reward ratio, I think it is more appealing at the moment, even if another decline is realized. However, the JPST, which is made up entirely of IG bonds and ABS, is a fantastic alternative if you want a great yield that is nearly entirely free of duration risk and even better than what you can get from Treasuries. JPST is currently preferable in my opinion because it offers a solid yield and makes it easy to avoid duration risk. From a 1-2 year perspective, I think (TLT)’s a good fit, but in the short term, there could be more price headwinds, even though that another downside move is limited to the lows we saw in 2023. In TLT, there could be additional headwinds if inflation really proves to be sticky and make the Fed act accordingly.

This thesis merely expresses my personal opinions about the state of the market, and I strongly advise you to conduct your own independent research before making any serious investments. I may be wrong as well, but this is how I currently see the bond market.