[embedded content]Jordan: Hello again everyone, and welcome back to the Atlas Investor Podcast with Tiho Brkan. Thank you so much for tuning in today for episode number 10. Tiho, my friend, it’s great to have you back for another episode. How are you today?Tiho Brkan: Thank Jordan, I’m very, very good. Thank you for having me back. We made it to episode number 10. That’s a little milestone, so that’s great. I also want to take this opportunity to wish you a happy birthday. I know for a fact that I’m outside of civilization once again, a western civilization that is. The timezone that I am in, happens to be your birthday, while the time zone that you’re in is officially not your birthday yet. Nevertheless, happy birthday my friend. I wish you all the best for 2018. What better present can
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Jordan: Hello again everyone, and welcome back to the Atlas Investor Podcast with Tiho Brkan. Thank you so much for tuning in today for episode number 10. Tiho, my friend, it’s great to have you back for another episode. How are you today?
Tiho Brkan: Thank Jordan, I’m very, very good. Thank you for having me back. We made it to episode number 10. That’s a little milestone, so that’s great. I also want to take this opportunity to wish you a happy birthday. I know for a fact that I’m outside of civilization once again, a western civilization that is. The timezone that I am in, happens to be your birthday, while the time zone that you’re in is officially not your birthday yet. Nevertheless, happy birthday my friend. I wish you all the best for 2018. What better present can you have than to spend your birthday or at least in my time zone, discussing treasury bonds.
Jordan: Yes, it’s a great way for you to celebrate my birthday is for you to give our listeners, our audience some great commentary and analysis on what’s going on here in the treasury market, the interest rate market. Tiho, before we get to it, why don’t you tell us just a few things you want to cover today in this episode.
Tiho Brkan: Sure, we’re going to look at what bond yields have been doing in the last quarter of 2017 and the start of 2018. It’s been interesting several months, and the bond market seems to be at a major inflection point. We’re going to look at the performance of various treasury maturities and the overall yield curve. We’re going to talk about the history of the treasury yield market. In particular, where we are in the long-term secular cycle and what might be happening in the years ahead. We’re going to finish with looking at the way that investors are positioned in the bond market and I guess, we can even discuss how I’m positioned within bonds.
Jordan: Okay Tiho, I think you said at the intro the bond market may be approaching an important inflection point. I mean, this could be from a bird’s eye view a major inflection point. I know we’re going to get into that but staring off here, why don’t you talk about the yield curve and what you see going on there right now.
Tiho Brkan: Sure. I mean, interest rates have been artificially suppressed since December 2008 under General Ben Bernanke, the savior of the global financial crisis and the helicopter money printer, as he’s known. And he goes down in history as a hero, according to one of the magazine covers. But we’ll see how much of a hero he is once the yield curve inverts again, that remains to be seen. We are not there yet. The yield curve has been flattening. We have all the major maturities now above the two percent in yield. We’re finally getting some interest back. It’s not a lot, but we’re getting back to some decent levels.
In particular, for the two-year, which is now paying the highest interest since 2008, just around the time, the Lehman Brothers was going burst. Yeah, in particular, the moves that we’ve seen over the last couple of quarters, has been the five-year nudge breaking out and basically, the yield has gone up towards two and a half percent, and catching up to the 10-year yield. That could be one of the first two maturities that inverts. In particular, also the 10-year yield has started to catch up with the 30-year yield. All in all, the yield curve just across the whole maturity, I guess, apart from the 30-year yield, has been under pressure with the price, because the yields have been moving rapidly higher.
When we look at the popular way to play the treasury market, basically you have two ETFs in my opinion. These are IEF and TLT, the intermediate bond and the long bond. What I want to discuss with you Jordan, is the way that the yield interacts with these two ETFs and the total return that they give investors.
Jordan: Yes, please go ahead and let us know what the total return right now looks like for both IEF, which is the seven-year bond ETF and then TLT, which is essentially the long bond ETF.
Tiho Brkan: Yeah. Basically, it’s very similar to the seven-year yield. The duration, I think, tends to be 7.8 in recent times. It kind of correlates decently well, but it’s not perfect. This is usually the way that people at home, small retail investors can now play the treasury market. What we have here, developments over the last week or so, have been that the seven-year yield is breaking up. That’s very, very interesting because we had the two-year move fast and the five-year move after that. Now, we have the seven-year yield breaking resistance and also the 10-year yield is kind of testing key resistance. First and foremost, we have a price correction in the IEF ETF, which is sitting on support or attempting to break below the support, while the yields have already moved up.
This has been a rather bearish picture since September of 2017 when we had a North Korea incident between Donald Trump, the president of the United States and Rocket Man, the North Korean leader, or as Donald Trump calls him. That was, I guess, a bit of a fearful and scary event, where a lot of the media publications were talking about a potential nuclear war and geopolitical risks rising. A lot of investors flocked to Treasuries. But as tensions ease, price declined and the yields rose. Now, we have a continuation of what seems to be a bond bear market.
The same story is not yet developing in similar fashion for the long bond, which has been a bit more resilient. The TLT term structure on the total return basis is still holding above the trend line, which I find very interesting. As of last week, we’re having a bit of a thrust on this downtrend line for the yield. The 3%, on the 20-year yield, which correlates closely to TLT, with the maturity and duration I think between of 17 to 19 years, is pretty close. What we’re seeing here is the 20-year yield might be breaking above 3%, which is a very important inflection point, Jordan.
Generally speaking, bonds have been under pressure. As you can see technically, the yield has been consolidating just below this trend, line, and it looks ready to break out. I’m not sure whether it will do that or not. We have to monitor the situation very closely. The tape so far is suggesting that yields want to go higher and the treasury price remains weak.
Jordan: Okay. Now, Tiho, I know that we’re going to get into positioning and sentiment. Is there something that you want to touch on before we get into that?
Tiho Brkan: Yeah. I would love to discuss where we are in the actual cycle of Treasuries because we ought to go back a hundred years or even the last 50 years and see how bond yields got here. We’ve got a very special chart for those of you watching YouTube or the ones that have gone on theatlasinvestor.com and are reading the transcript. I have put together a 90-year chart of the 10-year Treasury bond yield and some important events that went along with every single yield rise and how they influenced the economy, as well as other asset prices. I think we should spend some time on this Jordan.
Jordan: Tiho, why don’t you start by talking about the long-term cycle that intermediate treasury yields have gone through. We’re talking about the long-term cycle, we’re not just talking about like two or three or fives years. This is mega long-term, right?
Tiho Brkan: Yeah, basically, there are these cycles called the Kondratiev Cycles, by Nikolai Kondratiev, who was a famous economist. I think Stalin had him executed when he figured out how economics and capitalism worked. Stalin wasn’t interested in capitalism. Nevertheless, commodity prices, interest rates, and inflation tend to move in these long-term cycles of 30 to 60 years, and they swing depending on demographics and many other things that are involved. Since September 1981, when Paul Volcker a very strong man, tall man, intimidating man, who used to smoke while he was deciding where raters were going to go. He looked almost as if he was smoking Cuban cigars at the time.
He was a real intimidating federal reserve chairman. Under his watch, interest rates peaked at around 16% on the 10-year. He himself pushed the short-term rates above 20%. This was a time when gold peaked. He broke the back of inflation and oil was crushed in the following years. The bond bull market started in 1981 and also a year later in August 1982, the stock bull started. It’s been a terrific time for bonds ever since except the past year or so. In September 1981, the 10-year yield peaked at 16% and has been in a declining trend all the way into July 2016, I think, when they hit the trough of 1.6%.
They did hit a 1.3% trough in Eurozone Crisis of 2012, but these troughs are somewhat equal. One of the things that’s very, very interesting right now Jordan is the question of whether or not this cycle is ending and whether interest rates are breaking out.
Jordan: Yes, absolutely. On this chart, you have a trend line, a very nice trend line going back I think to the late ’80s and that connects many of these highs, of course, because the trend since 1980, as you said, has been down. This trend line since about 1986, ’87 is connecting all these peaks, but they are lower highs basically. Why don’t you tell us about the major downtrend and then finally zero in on the short term?
Tiho Brkan: Well, the economic growth has been really financed and has progressed mainly thanks to the amount of debt that we’ve been taking on. Clearly, as you can hear in the background, the truck driver agrees, because he probably financed that purchase with debt. I’m here in Vietnam doing this podcast and the debt here has been growing. Not to say that the global economy has seen a huge increase in debt levels since 2007. As the yields have been falling, so has the economic growth and it’s taken more and more debt to achieve that growth. For every dollar of GDP that we produce, we need more and more dollars of debt to continue the same kind of growth as years ago. If interest rates were to begin to rise, this could put a huge amount of pressure on servicing this debt and obviously, on the economy as well.
Every time that interest rates rose, they never made a higher high as you said. It was always a lower high. Nevertheless, every one of those lower highs that hit the top of the trend line that we’re both discussing right now, produced some kind of a crisis. In 1987, it was a stock market crash. In 1990, while the US wasn’t affected a lot, it was the savings and loan crisis, the Japanese stock and real estate crash, the fall of the USSR, fall of the Berlin Wall, as well as the Scandinavian banking crisis and the dismantling of Yugoslavia and several wars around the world as well. Then we had another rise during the bond massacre in the mid-’90s, which eventually put pressure on emerging markets and stocks, bonds and real estate assets in those countries.
Then we had another spike in yields from 1999 to 2000, and this triggered the tech crash, followed by a rise towards 5% yields in 2007, as Bernanke was the chairman of the Fed. He wasn’t smoking any Cuban cigars mind you, he was operating a helicopter or getting ready to. When yields hit 5%, they looked like they were almost ready to break out and the bond bear market was going to start. But that didn’t happen as the stock market went into a huge crash and we had a deflationary time for the next several years. Yields stumbled even lower. Yields did retrace and every time they did, they triggered a Eurozone debt crisis or an emerging market slow down or an oil crash. Every time bond yields spiked, we had some kind of a problem in economy and markets.
Now, the yields are not only hitting this trend line, Jordan, but they’re also attempting to break out above the trend line and move even higher. The10-year yield is attempting to move towards the 3% level. It remains to be seen how this will impact the economy. I just want to emphasize once again, the world has a lot more debt today than it did in 2007 during the last crisis. We haven’t fixed a lot of the problems. As a matter of fact, the European banking system is still in a similar place that it was before. Maybe we’ve improved slightly with some capital controls and improved liquidity ratios and so forth. However, I’m not so sure because the main improvements have just been thanks to Super Mario Draghi and general helicopter flyer Ben Bernanke.
Jordan: Yes, those two guys, they’re like the Michael Jordan or the Kobe Bryant of money printers or the Lionel Messi, for all you soccer fans out there.
Tiho Brkan: Yeah, I mean, look, they had to do what they had to do. The alternative most likely wasn’t pretty. I’m not going to get into the discussion of what should have been done. Obviously, it’s not up to me, I’m just an investor. It’s my job to try to navigate the asset markets. Having said that, there’s a group of clients that I have that fall towards the Austrian economic side of things. They would rather see sound monetary policies and they would rather see sound economic growth built on productivity and innovation, which we do have of course, as well. But without such high amounts of debt and low interest rates to entice people to borrow the debt.
On the other hand, I also have clients who are much more capitalistic in nature, and they know Keynesian School of Economics, but nevertheless, as long as they do well, as long as I do well for them, it doesn’t really matter how it’s done. Performance at the end of the day is the most important thing.
Jordan: Absolutely. Now, Tiho, with that being said, just one quick follow-up on this chart here before we get to sentiment and positioning. It looks like the 10-year yield is breaking out above the trend line. However, wouldn’t you say it has not made a higher high yet? Wouldn’t it have to go above that 3% peak to make a real higher high?
Tiho Brkan: Well, this is very true. We have Jeffrey Gundlach and Bill Gross, who are considered bond kings. They’ve been recently in the news with various media outlets discussing how the Treasury bond bull market is ending and how the yields are breaking above certain trend lines. What’s happening now is we’re entering a period, which will have, I guess, headwinds for bonds. One thing that I would like to say is exactly what you pointed out. We had a similar, not the same, but similar kind of a set up in the early 30s moving into early 40s. Basically, bond yields were declining from around 4% towards 2%. Nothing as dramatic as we saw from the 1980s to 2017.
Nevertheless, similar kind of a setup, and despite the fact that bonds broke this falling trend line, which was acting as a resistance for yields, that doesn’t necessarily mean the bonds now have to spike and go the other way in the exact same fashion that they came from. From 1940 to about 1955, just prior to the Eisenhower Recession in the late 50s, we had bond yields remain around 2%. That’s almost 15 years. We had bond yields trough during our investors’ generation at 2011/12 period during the Eurozone crisis. Wouldn’t it be interesting if bonds kind of just muddled along sideways from 2012 until 2027? That would really throw a monkey wrench in a lot of the bond bears’ investment thesis as well as the bond bulls because that’s the worst thing that can happen.
When yields stay low and they go nowhere, returns are really, really low. Don’t forget Jordan, this is exactly what happened in Japan.
Jordan: Oh, fascinating point, Tiho, I’m really glad you mentioned that. Now, let’s move on and talk about how people and investors and hedge funds and fund managers are all positioned in bonds right now.
Tiho Brkan: Sure. First of all, we look at the Merrill Lynch global fund manager survey. What we can see there is an extremely underweight position. The bond exposure is very low here. In previous instances, where saw this, the majority of the times, not always, but a majority of the times bond market has rallied. There have been periods as well where global fund managers would actually go underweight bonds to this extreme, and yet the bond market still declined for the following couple of months. Those instances are quite rare. Majority of the times whenever bonds are sold off, and fund managers have been this underweight, bonds have fared pretty well.
Moving along, away from the global fund managers, we’re also looking at hedge fund positioning by futures. Now, hedge funds have been very much shorting the treasury bond market, in particular, the five-year bond and now recently, the 10 year bond. They’re also starting to get short the 30-year bond too in recent weeks. When you group it all together across the yield curve, hedge fund managers have really been pressing their bets against Treasuries and in particular since the North Korean saga in September. Usually, whenever hedge fund managers turn extremely net short in a certain market, prices tend to really get away. I consider them dumb money.
In this instance, and this has also happened during the taper tantrum in 2013, as well as during the US elections in late 2016, early 2017. Both times when hedge fund managers went extremely short, what ended up happening was bond prices rallied and yields declined. That was positive was bond investors. This time around, we seem to have a break of a technical uptrend line in an ETF like IEF. Whether this is going to be a real break with a follow through or just a fake out, from which there can be a reversal, remains to be seen. Whether the stock market, which has gone parabolic, starts to correct, also remains to be seen. One thing is for sure, whether it’s the global fund managers or whether it’s hedge funds in the futures market, or whether it’s the sentiment surveys itself, the majority of the investors are heavily pessimistic and shorting treasuries. They are all positioned for higher yields.
Jordan: Yeah, I have a big picture follow-up to that, but I’ll wait until a little bit later because I want to talk about the Atlas Bond portfolio. Can you tell us how that’s been performing, what you’re doing with bonds, what you have been doing and what you’re doing now if you can share?
Tiho Brkan: Sure. Well, we have our own benchmark within the overall portfolio and there’s a certain allocation that we sometimes tend to put on (depending on the conditions) and allocate towards bonds or fixed income. This includes government bonds in the United States, as well as treasuries outside of the United States. It also includes credits such as corporate junk or emerging market debt. Some of it is in local currencies and some of it is in hard currency like US dollar denominated. As you might recall Jordan, as well as regular readers and followers of Atlas Investor, I become extremely bullish in bonds in November and December of 2016, just after the elections, and just after the treasury market decline.
As a matter of fact, my Twitter was littered with bullish reasons why to buy bonds and not just Treasuries, but all kinds of bonds. That includes credits, emerging market debt and so forth. I was extremely optimistic about bonds around that point in time, and our portfolio benchmark had a drawdown of more than 10%. We ended up buying that and holding the majority of our credit until I think November, or even just before November or October, around the time when the North Korean geopolitical incident was happening. We sold some of the treasuries there as well as some of the treasuries actually earlier too. We didn’t hold the treasury market the whole way through 2017.
That’s been a fantastic trade for us, despite the fact that yields were low. Since we use some leverage, the returns were better and they were magnified. Having said that, the overall bond portfolio that we track almost reached a new record high ending 2017. There was, in my opinion, not that much value left, especially when you look at Treasury yields having negative forces and headwinds. They’re breaking out as you mentioned before and also credit spreads have narrowed so dramatically that investors are not compensated for the premium and the risk that they’re taking right now.
There’s not a lot of opportunities left in the bond market at this juncture. I do think that various treasuries are slowly, the maturities of treasuries are slowly becoming oversold. That might be an interesting inflection point coming up quite soon for the government bond side of things. Credit, not so much.
Jordan: Yeah, I just have one or two follow-up questions on that. I know we can talk more about that in a different episode, but if credit spreads start to widen, is it possible that could put some upside pressure on treasury bonds? Can they be a safe haven bid out of that? Or have there been times in history; I know there isn’t that long of a history with junk bonds, but can you envision credit spreads widening, and then treasury bonds selling off at the same time?
Tiho Brkan: Yeah, of course, it’s definitely possible. If interest rates were to rise as they are right now, due to the fact that we do not have a recession and corporations are still performing well, credit spreads are narrowing and credit is outperforming government debt. But there could be a period in time and despite the fact that we don’t have historical data to prove this as junk bonds were only started in the ’80s and emerging market debt in the ’80s and ’90s, it’s very difficult to look back to the history. This cycle has been under the falling yields regime. I would definitely think that during 1950, the ’60s and ’70s, whenever the stock market used to sell off, the Treasury bond market to sell off and the yields would spike.
I think spiking yields would also produce a spike in corporate yields, but to an even high degree, because as stock market equity sections sell-off, so does the debt section too. During that event, diversification might not work very well, and risk parity investors and portfolios might actually suffer or at least underperform. One has to be careful. Having said that, during those periods, asset classes such as gold, in the ’60s and the ’70s, as well as commodities in the 70s, performed really, really well. They were actually the empty correlation asset class, which would create some kind of a safety whenever stocks and all kinds of bonds and credit sold off.
Jordan: Right, yeah, that’s great information and analysis. My other question, I guess is more of a comment that you’ve said it before, it’s an inflection point. What’s fascinating to me Tiho is if you look at the price action, you can’t base everything on the price action in the chart. It just looks so bearish, so ominous, yet you factor in the sentiment from a contrarian standpoint, the sentiment supports a rebound. Yet the treasury bonds are not that oversold. I mean, they haven’t declined that much. You have some interesting factors coming up here in other words. In other words, the sentiment for bonds would support a rebound. Technically bonds look really ominous, but they’re not that oversold, so they could potentially drop more or even break down before they have some kind of a rebound.
Tiho Brkan: Well, I would love for that to happen. Any asset investor or any asset allocator loves to buy low or should aim to buy low and sell high. If bonds were to correct like they did in November and December of 2016, honestly, I was licking my lips and I had several clients tell me, it’s going to be a big mistake if you buy bonds. We’re not going to make any money, and it proved to be a very, very good investment. The same can be said if an investor had the courage to buy the Taper tantrum as well during early parts of 2013 and the middle parts of 2013. Both of those proved to be very, very good inflection points to jump in and buy bonds.
At this point in time, we don’t have anything like that yet. I want to give some merits to your analysis and your point that you made Jordan because I know so many investors, some of which are extremely intelligent, I mean, they write the most amazing pieces. They’re incredible at the way that they trade, and invest and think about financial markets. One thing that they don’t do is they don’t listen enough to the actual tape of the market, just the way that you did. There’s always a handful of reasons to buy something and a handful of reasons to stay away from that same asset class. You have to figure out which signals to listen to.
The signal that I listen to the most is usually price. That’s the most important. It sounds so simple and yet so many investors fail to follow this. I listen to price and if the price is not agreeing with my narrative, I refuse to think that I’m smarter than the stock market and the bond market. Time and again, we see some of the most spectacular investors who believe in their own narratives and their own stories, and they think they’re smarter than markets; they will buy some stock at a hundred dollars, which would go to $1. Or they would buy the bond market believing that a certain event would happen and it doesn’t happen and the yields go against them and the prices go against them.
They continue to hold because they think they’re smarter than the market. Yes, I totally agree with you. Regardless of what we think, we should look at what the market is telling us. After all, it’s not the job of a speculator or an investor to be correct, that’s the job of an analyst. I’m not an analyst, I’m an investor. My clients judge me by performance. They don’t really care if I said that bonds should rise or bonds should fall. They just look at the quarter end or year-end statement, and they say, “Oh, you did well, or you didn’t do well.” How you get there is usually, most of the time, completely up to you.
I like to exercise prudent investing, discipline and the right risk management. I think at this point in time, regardless of how one thinks, whether yields will stop right here and create another risk event as they have since 1987 when we covered that beautiful chart going back a hundred years. Or whether yields would actually break out and rise past 3%, which is the next resistance. That’s anyone’s guess really. Nobody has the capacity to predict the future. They can just speculate on the future. I’d rather speculate with the trend than against the trend. That’s a bit of wisdom that I would put in here.
Jordan: Okay Tiho, well, that wraps up episode number 10. Great work today. You know Tiho, I really hope that we can follow up on the bond market in the months ahead or even the weeks ahead if we see further important developments. What do you think?
Tiho Brkan: Definitely, we’ll keep a close eye out and we’ll do another episode if something major changes from the current episode. In particular, I really enjoyed covering the bond market today and I hope listeners, readers, and YouTube watchers enjoy this as well.
Thank you for listening to The Atlas Investor podcast. To be notified of future podcast episodes sign up for our free newsletter and join our Youtube channel. Tiho Brkan offers his clients a wide range of services. Including portfolio construction and wealth management. One on one consultations. Global real estate opportunities. International tax planning. Citizenship and residency planning. And one on one mentoring. For a free consultation, visit the Atlas Investor dot com and contact Tiho Brkan.