Jordan Roy-Byrne: Hello again, everyone. Welcome back to the Atlas Investor podcast with Tiho Brkan. Thank you so much for tuning into this episode which is number 16. Tiho, my friend, how are you, and what will we be covering today?
Tiho Brkan: I'm very well. Regards from Europe. Happy to be doing episode number 16 with you, Jordan. Today, we'll be covering the most interesting of all asset classes. The classical joke that I always make when we talk about fixed income. Today we'll be looking at government bonds and credit.
Jordan Roy-Byrne: Tiho, let's start with government bonds. I know you made that joke, but it's very interesting to me and many others right now because if you look at Treasury yields, particularly the 10-year and the 30-year, we could (and you said it before, you noted it in episode 10 when we last covered it) be at a very important inflection point for long-term interest rates. Could you just explain that and where we are in the long-term rate cycle?
Tiho Brkan: Of course, so we covered this in episode 10. For those that haven't listened to it, go download it or go read the transcript at theatlasinvestor.com. Then we discussed the long-term cycles and the long-term interest rate trends, and the last period where we saw rising rates, was from the 1940s to 1981 in September, and since then we had a declining trend in yields, until 2012 as well as 2016, with a potential double bottom in the 10-year Treasury. We hit 1.20% in the first part in 2012, and then 1.30% later on in July 2016.
If you remember the article published in Market Watch, I called the bottom in interest rates and yields as well as the top in bond prices as well as various other safe havens at the time, which were high-quality stocks, dividend yielding stocks, in particular, US REITs. All of these are rate sensitive and rate proxy sectors.
So, since (July 2016) we've had a sharp move up in yields followed by a consolidation below this important trendline, which dates back all the way to 1987. This falling trendline has been broken and bonds have been under pressure for the last six, seven months, especially the short duration. So the short maturities from two to five to seven (years) and now even the 10-year. We see it in the magic number that everybody in the finance industry is discussing which is 3% yields, and last time we were there was in 2014.
One thing that I want my readers, listeners, and followers to understand is that while this doesn't always happen, the majority of the time, whenever interest rates rise and they rise sharply, it could trigger some kind of a crisis in the economy as well as in financial assets.
Throughout the last 20, 30 years (for those following on YouTube), you can see the chart…we've triggered various crises, and maybe since yields are starting to rise once again, and if we break above 3% and move higher, it could perhaps trigger an eventual bear market for stocks, Jordan, so it's something to keep an eye on.
Jordan Roy-Byrne: Okay, very interesting, Tiho. Now let's talk about the yield curve and what's been happening there. We've seen sharp rises on the short end but not quite as fast of a rise in the long end. But interest rates across the board are moving up. So how is that reflected in the yield curve right now?
Tiho Brkan: Yes, so the yield curve is very similar in some ways, not all ways, but very similar to when general Ben Bernanke, the king money printer, was in charge in 2005, and basically he was behind the curve back then. And what we mean by behind the curve refers to the tightening of monetary policy. The Federal Reserve should, in theory, follow the two-year yield.
They should be about 50 basis points away to give themselves some flexibility, and Bernanke was very, very far away in 2004 and 2005, and he kind of was doing a step by step, once a month gradual hike, doing two or three hikes per quarter so to speak, until it triggered something and broke something in the financial system and created a bear market, and nobody knew at the time, but a near Great Depression 2.0. At present we have this flattening of the yield curve and the fed is behind the tightening pace that it should be following.
And on top of that, we have this very interesting setup in the 30-year yields. Basically, it's around 3.25% that we have a major ceiling or resistance, and yields haven't gone above 3.25% on the 30-year long bond since 2014. In 2015, 2016, and 2017, we've seen a resistance there, and that is the one to watch because, Jordan. This is the last part of this federal yield curve. This is the last maturity to break and start making higher highs in terms of yield.
This would basically confirm that we're potentially in a secular long rising yield environment. So this is really important to watch. It could be a head fake, of course. We could have a breakout and then something catastrophic and deflationary happens, and then the markets react by pushing yields down very low again. There are plenty of perma-bears out there who think that yields are still going to zero or even negative.
Some of them that are quite famous including Soc Gen writer Albert Edwards, who has been saying that the 10-year US Treasury will eventually get to 1% and lower and even possibly touch zero when the next bear market happens. But that was five years ago and the next bear market hasn't happened. Maybe it'll happen in the next five years.
Jordan Roy-Byrne: Okay, Tiho, I want to come back to the importance of where long-term yields are right now. You noted the 30-year that's at a very important resistance zone around 3.25%, and then also the 10-year is in the same picture right now with respect to testing major resistance.
Now, let's talk about sentiment and how sentiment factors in, Tiho, because as you've probably seen, there's been people all over the media talking about a big breakout that seems almost imminent, yet when you look at sentiment, or at least when I look at sentiment, it seems really extreme. We talked about it in episode 10, how sentiment even then was fairly stretched on the bear side. It's even gotten more stretched in my opinion, so how does that factor into the near-term outlook for the market right now?
Tiho Brkan: Sure. Well, let's cover the sentiment together with the price, and what's happened since episode 10. The sentiment was quite stretched in the sense that we had quite a lot of bears, and commitment of traders report was showing commercials buying Treasuries. If we look at the price, so let's say the middle maturity, something between seven to 10 years, which we can follow with the IEF ETF.
We had a bit of a rebound of support from the drawdown, so we hit about 8% drawdown. We hit a classic support around 101 dollars per share for this ETF, and we rallied back towards the three-month moving average. So we had a bit of a short covering rally and a rebound from negative sentiment, and we've quickly fallen back down as yields have risen sharply.
Now, sentiment has become even more stretched this time around as you said. Sentiment surveys are showing very low readings, and the positioning across the yield curve is quite short with, for example, 10-year maturity. The commercials (also known as smart money for those of us that follow commitment of traders report), they hold record net long positions.
In other words, speculators and hedge funds are short in the Treasury market like there's no tomorrow. Everyone's positioned for Armageddon or a yield spike, and that might not happen, Jordan. So we could have a major short covering rally here from a double bottom.
Generally speaking, the performance for the Treasury notes and the Treasury bonds has been quite awful over the last three to four years. Barely any returns whatsoever. Kind of moving sideways and this is what Treasury bear markets look like. People think it's very intelligent to short bonds, and we've discussed this before, I think, in episode 10 and one of our early episodes.
It is not smart to short bonds unless you can pick the right time to short, be in the trade for three to six months, catch the downtrend or the down leg. Then usually you have a rebound because what happens is that eventually Treasuries will pay the constant yield that they pay, and that's the cost of you having to short a maturity, and obviously lower the duration, less price movement. And as the interest rates continue to rise, it costs you more and more money to hold a short. So it's not as if shorting Treasuries, in particular, lower duration, is smart.
It's more the fact that Treasuries are basically giving us a flat nominal return, and eventually, according to history, and one can go and look at the 1950s to 1970s, government bonds or any kind of bonds, whenever they're flatline in nominal terms, they're actually losing a lot of value in inflation-adjusted terms. So Treasuries have had poor performance over the last four years. The question is can Treasuries have several months rebound from here because sentiment and positioning are, as you stated yourself, well set up for that.
Jordan Roy-Byrne: Tiho, before we get into the credit markets, let's talk about how international Treasuries are performing because I know there's some difference there, and also, the dollar appears to have put in some kind of a low here. Can you talk about that and what you see going on in the global Treasury market?
Tiho Brkan: Yes. If you look at global Treasuries, you are not looking at emerging markets. We're looking at Eurozone. We're looking at several other developed bond markets like Japan and South Korea, Singapore, Hong Kong, Taiwan, where there's some kind of depth and liquidity to the overall market. In particular with Eurozone, you're looking at gilts from the UK, you're looking at bunds from Germany, you're looking at Italian debt, you're looking at Spanish debt, and so on and so forth.
And because of the ECB's and BOJ's programs, their yields have fallen even lower, and the interesting thing and maybe even the funny thing for some of our listeners is that the US Treasuries are now basically the higher yielding Treasuries of the world. They're in a high yielding basket. If you were divided into low yielding, intermediate-term kind of medium-term yield, and then the long yield…the actual higher yield that you will receive due to holding that asset, US is actually the most attractive there other than several other countries, so it's in the high yield basket, which is very interesting.
So clearly, global Treasuries are not a great asset class to hold unless you can judge the movement of the US dollar as you said. So the US dollar peaked in December of 2016 and has been in a correction mode. Basically, almost all of the gains from the international Treasuries excluding US Treasuries have come from currency appreciation of local currencies and currency depreciation of the US dollar.
Since this ETF or the asset class is priced in your dollars, where you really made gains was betting on the right movement or currency. Not much more to it than that, Jordan. So international Treasuries now are obviously breaking their uptrend, declining because the US dollar's going through a fierce short squeeze, something that we'll be discussing in the near term in the next podcast or so.
Jordan Roy-Byrne: Now, Tiho, let's focus on credit spreads in the credit markets. First, why don't you give us an overview including a little history, and then secondly, where we are now as far as credit spreads?
Tiho Brkan: Sure. Well, we're very tight historically speaking. So credit spreads have narrowed dramatically since January or February of 2016. Now for those that are following on our website or YouTube channel, they should be able to see history dating back some 40, 50 years.
Basically, it is not a very dramatic warning signal when credit spreads get too tight. First and foremost, it means that you're not going to make a lot of money in credit relative to holding equal or similar maturity Treasuries. And Treasuries could outperform since Treasuries are called risk-free investments. In my opinion, that's wrong because there's no such thing as risk-free. We just discussed how Treasuries have underperformed, and there is a chance of losing a lot of money over the long term in inflation-adjusted real terms, so it's definitely not risk-free.
But risk-free as in getting your money back, that's what the term means, and the return of your capital. So from that aspect, we have a mean reversion in credit spreads or corporate credit spreads throughout history, and you have periods where credit markets outperform Treasuries and periods where Treasuries outperform the credit markets.
In the last two years, we had a period where credit dramatically outperformed Treasuries. Generally speaking, that's actually been happening since March 2009, or better yet said, I think, it was October, November 2008 when credit bottomed. So, credit has done wonderfully well, and I think now you are trying to squeeze the last few little drops out of a lemon. You're kind of like clipping coupons here and just trying to match the same return the Treasuries are going get on maturity. But you're much better off holding Treasuries than being in credit because we are very, very tight here.
One of the things that I would also like to say that is connected to the stock market, Jordan, is that whenever credit spreads spike, usually I say to my clients, credit spreads spike, it's time to buy. So whenever they're high it's time to buy.
It's a very interesting analogy, and if we look at all the crises' from 1970 including the Bretton Woods collapse, Middle East oil embargo of '74, double-dip recession in 1982, and the petro-crisis, and 1987 stock market crash as well as the fall of the Berlin wall and the fall of the USSR, the Japanese economic crash, breakup of Yugoslavia in 1990 was a big one, savings and loan crisis wasn't felt a lot in the United States. But the rest of the world really felt 1990. That was a catastrophic recession even in Scandinavia with the collapse of the banking system and so forth. We had a slight jump in credit spreads.
In 1988, Asian financial crisis and Russian bankruptcy, September 2001 with the bombing of the towers, technology bubble bursting at the end of the early 2000s, 2002, 2003, and then the global financial crisis as well as Euro debt crisis in 2011, 2012, emerging market slow down in 2016… all of these dates, they connect to an interesting or in some cases a wonderful buying opportunity for the stock market. Now Jordan I'm sure you have a handful of questions regarding that.
Jordan Roy-Byrne: Well, actually, one question I have for you, Tiho, is you noted when it's high, it's time to buy as far as the credit spreads, but on the other hand, when it's low, it doesn't necessarily mean that it's time to sell because I'm looking at the chart, and you can see some examples. Credit spreads were very low in 2005. You still had two years to make money on equities. I'm also looking in late '94 or early '95, you still had a great run in US stocks. I know other parts of the world really struggled there in the mid to late 90s.
You go back to about 1979 or 1980…maybe that was a little bit before a generational buying opportunity. Another time they were fairly low, it looks like around 1984. So correct me if I'm wrong, but if credit spreads are so low, that's not necessarily a sell signal.
Tiho Brkan: You're definitely correct in that aspect, Jordan. As I said before, what it usually means when credit spreads are low is you should sell the credit assets themselves, your credit holdings. And probably if you have a diversified portfolio, you should switch that credit into Treasuries of equal or similar maturity and duration. So when credit spreads are low, it's not necessarily time to sell equities. At times it has been a warning flag, and sometimes it's not US equities that get punished. Sometimes it's in another part of the world that is affected.
For example, in 1994, we had the tequila crisis, and in 1997, when credit spreads were low, we had the Asian financial crisis. So if, when credit spreads were low in '97, you should have sold Indonesian stocks because if you didn't and you were holding them, you would have lost 90 percent. But it's hard to read that at times. Indonesian, Filipino, Singaporean, Hong Kong stocks, they all were decimated during that period. Not only stocks but also real estate, too.
But having said that, there's been times when credit spreads were low, and the global equity market kept running hard. For example, 2005, 2006, and even into 2007. Finally, in 2007 at the end, credit spreads gave a divergence and equity markets started to fall, but let's not forget that equity markets like Russia, Brazil, that were connected to commodity cycle during that period, they didn't peak until 2008. So it took another two, three, four years in some cases, and those runs at the end of the great bull market, they usually go parabolic at the end, so you can make a lot of money if you have the experience, the skill, and the foresight to stay until the end, but that's very difficult to do.
Tiho Brkan: Generally speaking, what I do and how I operate is that I look at when credit spreads are high. That's when there's usually value in the stock market, and as we said, when spreads are high, it's time to buy.
Jordan Roy-Byrne: Okay, Tiho, so that covers investment grade spreads, and thank you so much for that terrific analysis on the last 50 years. There are some great takeaways, and there are some great nuggets that you gave us. Now let's move on and focus on the rest of the credit markets. Tell us what has been happening with respect to global corporate credit spreads.
Tiho Brkan: Yes, so when we look at the overall credit market (we just discussed investment grade), and when we look at junk and when we look at emerging markets, the interesting thing is that emerging markets and investment grade spreads have had a recent uptick from very low levels, but junk grade spreads (the spread between junk and Treasuries) they're actually still doing very well.
The triple Cs, which are not in the chart for the YouTube followers and the blog readers, they're actually just tightened to the best or the tightest level for the overall cycle, which is incredible. So that's telling you that there's not a lot of issues there, at least there's a lot of energy components there, and so forth.
If there was a major problem in the financial system, you would think that for these very low-grade assets (which might not even be assets), when the cycle turns, a lot of the defaults happen here. They will show first signs of stress, and so far the spreads are not widening.
They're actually tightening. So junk is doing very, very good. But as I said, investment grade and emerging markets are under a bit of pressure. So how about we cover investment grade bond prices first, Jordan?
Jordan Roy-Byrne: Absolutely. So tell us how have they been performing? I know that you have a chart here for the followers on theatlasinvestor.com and on YouTube, and it looks like technically we have a bit of a breakdown.
Tiho Brkan: Yes. Well, basically one of the things that's very important, (and even if we go back to similar-maturity Treasuries, which is the IEF ETF, one thing that investors should know is that the major inflexion point for the whole fixed income was around the North Korean saga back in September of 2017.
That's also around the time that the Fed embarked on its quantitative sales of its assets, basically, they were doing the opposite of the QE, so they're doing quantitative tightening. I think everyone's now calling it QT instead of QE. And that's the inflexion point there, like North Korean geopolitical tensions as well as the fed embarking on its selling program of its assets. Since then investment grades have been under pressure.
They did make a slightly higher high, but they've been under pressure ever since then, and the performance has been rather average for the last six months, and they are breaking down from technical trendlines. The drawdown is now at 5%, which is very similar to the drawdown that we saw during the US elections, and the followup after the US elections when Donald Trump won. So that's quite a disappointment for those who are holding this asset class.
Moving along to junk, higher-yielding junk bonds, they're actually outperforming the overall credit space and the overall fixed income space. And furthermore, junk bonds actually are outperforming all of the assets on the drawdown basis. So before I get into junk bonds here and analyze them, I would just like to say that when one looks at the actual drawdowns of various asset classes, one comes to the conclusion that junk bonds are actually the safe haven, Jordan. I'm not sure how this came about, but markets at various times do various things that are kind of puzzling, and we can't really explain why.
So if we think about it as of this exact moment when we are recording this episode (May 1, 2018), US stocks are down about 8% from their all-time highs. International developed market equities are down about 7% from their all-time highs, and emerging market stocks are down about 11% from their all-time highs. Intermediate-term duration US government bonds, the Treasuries, are down 8%, while the long bonds are down between 14% and 17% depending on which duration you hold, all the way to the zero coupon. Corporate-grade, investment grade, as we just discussed is down about 5%, and we'll be discussing emerging markets next. They're down about 5.5%. Gold is down about 30% from its all-time high, and even MLPs are down about 40%.
Now there was one asset class that sticks out, and that's the junk bond market. It's down only 2% from its all-time high. Several weeks ago, you almost made a new record, so junk bonds are faring very well. They have been since the North Korean geopolitical tensions. They've been kind of moving sideways as well, not really performing all that well, but still holding their own and doing much better relatively speaking than the rest of the fixed income space, obviously the rest of the credit space, and the rest of the overall global macro-asset classes.
Jordan Roy-Byrne: Tiho, I know it's not part of the credit markets, but you didn't mention Bitcoin and how it performed, and perhaps some of that money from Bitcoin has found its way into junk bonds.
Tiho Brkan: Well, from one junk to another, right? So, why not.
Jordan Roy-Byrne: Jokes aside, Tiho, let's move on and talk about how emerging markets, dollar-denominated bonds have been performing. You have a chart here for our followers on theatlasinvestor.com and on our YouTube channel. Tell us what you see in this chart and how emerging markets, dollar-denominated bonds have been performing.
Tiho Brkan: So, obviously as you mentioned hard currency denominated, dollar-denominated. So for these bonds, there is not that much of an impact from currency movements like for international Treasuries as we talked about previously, and also emerging market bonds, denominated in local currencies.
They swing a lot based on what the US dollar does. From that aspect, not that much of an impact, but having said that, this is a risk proxy that's kind of acting half like the stock market and half like the fixed income investment grade or even sometimes even correlates to Treasury markets as a safety.
So at times, you've seen emerging market bonds rally really well when the Brexit happened and stocks declined, and they've also rallied very hard when stocks corrected during the North Korean geopolitical tensions.
But at times they've corrected with stocks similar to, for example, emerging market stocks in particular, when the US election happened, or when oil was falling and bottoming out, or China was crashing and devaluing its currency in August 2015, or now we're going through trade war fears. So emerging market bonds are also declining, which means that basically the yields on emerging market bonds are rising, and therefore the spreads are widening as you said.
Investment grade is seeing a widening in spreads, and so is emerging markets. Junk grade, funnily enough, is holding its own so far. This asset class has done really, really well, Jordan, over the last two and a half years. But over the last three months or so, it's been performing very bad.
In particular, I think the inflexion point for the whole fixed income space came around North Korea geopolitical tensions in September and also when the Federal Reserve, as I just mentioned previously started offloading its balancing sheet. From that point onwards, emerging market bonds couldn't make that much of a higher high. It was a false breakout.
Eventually, the trendline broke, and now it's declining. The drawdown is now 5.5% and it could get worse in the next few days if the selloff continues. But they had an incredible performance from January 2016 when oil bottomed and the Federal Reserve blinked, and basically, they went on a pause. They didn't want to hike very quickly after that first hike in December 2015. Emerging market bonds had a terrific rally, so I think we're just in a bit of a mean reversion. And it was really overdue because this asset class was overbought, but nevertheless, it still offers the highest yield when you look at all of the asset classes denominated in US dollars.
Emerging market bonds still offer the highest yield, but my caution here is that credit spreads tend to start to widen as we enter late cycle and move towards a recession. Eventually, you don't want to be holding credit (as we are in a late cycle) towards the recessionary part of the cycle because credit will underperform Treasuries.
So I wonder if this is an early sign of global investors moving away from riskier assets like credit because they're just not getting that much more of a benefit relative to holding Treasuries. And they're basically getting into Treasuries now because the yields have moved up so much. And as I said, US kind of looks attractive relative to the Eurozone and Japanese bonds.
Jordan Roy-Byrne: Okay, Tiho, so let's wrap up everything that you've covered here so far. First off, tell us what your outlook is on Treasuries.
Tiho Brkan: So from the short-term aspect, Treasuries have been under pressure for the last several months, and the last time we discussed it in episode 10, the sentiment was already bearish. The sentiment is getting even more bearish now. Hedge funds are holding in some cases record net short positions against Treasuries. In other cases, futures traders and other investors who are surveyed are showing very high levels of bearishness towards this asset class, and even global fund managers and funds, in particular, are very underexposed to this asset class.
So generally speaking, the asset class is very much hated, and from there you can have a short covering rally. There is enough fuel for that. But one of the key components in the yield curve is towards the 30-year yield and whether it will break the resistance at 3.25%. If that happens, maybe yields across the whole board could continue to rise a bit more, and Treasuries could continue to be under pressure. As a matter of fact, the whole fixed income space would be under pressure further from there.
For Treasuries, I am a little more cautious, and I'm watching whether we will have positive price action to confirm that the short covering rally is underway, Jordan.
Jordan Roy-Byrne: Okay, thank you, Tiho, and finally, why don't you summarize your views on the credit markets. I know the credit markets are so big and vast, there's a lot to cover there, but maybe touch on what you think our audience needs to take away from your extensive analysis.
Tiho Brkan: Well, the credit spreads are quite narrow relative to equal or similar maturity Treasuries. From that aspect, I don't really want to be owning too much credit, and we are in a late cycle, which means that you're not going to make a lot of money by credit spreads tightening that much more dramatically where they outperform Treasuries.
On the other hand, credit is one of the first asset classes to start underperforming just prior to a recession as spreads start to widen. We've seen numerous times before credit spreads widen, and there's not even a recession or equity markets can still continue to move higher. And you've made that great point when we were discussing that earlier in the podcast, Jordan. So credit is something that in a late cycle you really don't want to be dramatically exposed to.
There is a little bit of value if we think that the economy will continue to boom. One might look at investment grade or even emerging market debt because the drawdowns there are about 5%-6%, and if we have some kind of a reversal together with the equity market where the correction could stop, perhaps we could have a rebound there.
And in the case of emerging markets, somebody could say, well, if they're going to rebound together with equities, why don't you just own equities? My case is that they have a lower volatility, so in a risk-adjusted basis, you could, in theory, take more risk, and for every five percent you make in emerging market bonds, it could be actually better for you than making 7%-10% in the S&P 500 for example.
It depends on how much leverage you use and how much risk you're willing to take when deploying some capital, and how your portfolio is really set up. But generally speaking, credit is not something that I want to be highly exposed to at this point in a cycle.
Jordan Roy-Byrne: Okay, Tiho. Now, before we sign off here, why don't you tell us what we have planned as far as what we're going to be covering in the weeks ahead?
Tiho Brkan: Yes, so there's some interesting podcasts coming up, and there's going to be more routine to the podcast because my travel schedule is a little bit down. But recently I travelled around Asia, and we're going to cover some of those places, some of those wonderful places that I visited as well as resided in some parts.
So I lived in Hong Kong before. We're going to be covering Hong Kong, and I was recently in Hong Kong doing some business only a week or two ago. So Hong Kong is a very interesting jurisdiction. It's a two system, one country kind of a jurisdiction. It's still part of China, but obviously still has its own political system and its own currency and its own stock market and its own bond market and so forth. Very interesting jurisdiction, and something not to be missed.
We're also going to cover Vietnam, most likely in a two-part podcast, part one and part two, focusing on the economy of Vietnam and reopening of Vietnam, as well as the asset classes and how one at home looking at this overall picture of Vietnam could invest in Vietnam. For example, let's say you are from the United States or from Australia or from other developed countries such as France and Germany or the UK or even Sweden. So that's very interesting as well.
Also, we will keep tabs on the stock market, on the fixed income market, as well as currencies and precious metals, which I think we're going to cover very, very soon, Jordan, most likely in the next episode. So I know you're a big fan of gold, and this is your forte, so you'll get your chance to shine as well, my friend.