The Buy Signal No One Sees Coming
If the Federal Reserve is ending rate hikes, that means we’re reaching peak interest rates. And if you’re a bond investor, that’s a huge deal… because, if the coupon payment on sovereign debt isn’t going higher, soon you won’t be able to lock in today’s high yield.
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Wealth Signals features commentary that filters out market "signals" from the "noise" that is the mainstream financial news media. We focus on what matters – which, invariably, is not what you’ll hear on CNBC or read in the Wall Street Journal. On the basis of these signals, we’ll also issue macro-driven trade ideas to get ahead of the trends and themes that will dictate market direction.
Whatever the talking heads on CNBC are saying, this is the reality: The Federal Reserve’s rate hike cycle is ending… and history shows that right now is a fantastic time to buy bonds.
Here’s why: A key inflation signal has flipped positive. This means the investment environment for certain assets is becoming more favorable. (Fed Chair Jay Powell has hinted at a “pause” in interest rates… and the data makes it all the more likely.)
This signal has happened only six times since 1959. And each time it occurred in the past, it led to an average 8.1% annualized return for the S&P 500 Index over the following two years.
However, this particular trigger has created an even more compelling opportunity in the bond market.
Today, we’ll show you two ways to invest in bonds that we believe will deliver for investors seeking capital gains, as well as those looking for steady income.
Here’s how it works...
Lightning Strikes a Seventh Time
Since the start of 2022, the Federal Reserve has had one primary goal… get inflation growth back under control. Because, with the introduction of trillions of dollars in stimulus by Congress in early 2021, demand for goods exploded higher. And so did costs.
American consumers suddenly flush with cash bought everything. Manufacturers couldn’t keep up with demand. They scrambled for raw materials, to produce more stuff to sell to cash-rich consumers.
So, as supplies of items like cars, homes, and iPhones dwindled – and as supply chains struggled to keep up – prices rose. It led to runaway inflation. In fact, by June 2022 the Consumer Price Index (“CPI”), which measures inflation based on out-of-pocket costs, hit 9.1%, the highest level since 1981.
The Fed had to act – or else, inflation would get even worse.
So, starting in March of last year, it began raising interest rates. Since then, they’ve risen from 0% to 5.25% as the Fed has tried to cool price growth. That’s the fastest pace of any cycle going back to 1982.
The good thing is that the plan is working, and inflation is falling. Year-on-year CPI growth dropped to 4.9% in April compared to that June peak of 9.1%. That means inflation growth is falling below current interest rates. In the past, the Fed hasn’t stopped raising interest rates until this happens. And CPI appears poised to fall even more in the coming months.
But there’s an even more important signal. The central bank’s preferred inflation gauge, core Personal Consumption Expenditures (“PCE”), just fell below the current interest rate (effective federal funds rate) as well. That should give policymakers breathing room to stop raising rates and start cutting down the road.
For investors in government bonds, that’s a huge deal… because the end of the rate hike cycle means yields aren’t likely to get much better. In other words, that’s the opportunity to lock in peak rates.
So, we wanted to see how many times in the past the Fed’s preferred inflation gauge has dropped below the current interest rate – and what happened next. This has happened only six times since 1959 (when PCE was first developed as an indicator) … in 1961, 1971, 1972, 1977, 2004, and in 2018.
Take a look…
PCE data is produced every month by the U.S. Bureau of Economic Analysis. It measures the cost of goods for households based on prices charged by businesses. (That’s distinct from the U.S. Bureau of Labor Statistics’ CPI figures which, as mentioned above, measures inflation based on out-of-pocket costs.) The core number is a bit more specific because it eliminates the volatile swings of food and energy prices.
The core PCE number for March was 4.6%. When we line that up versus the current effective fed funds rate of 4.83%, we’re positive.In other words, core PCE will fall below the effective fed funds rate for only the seventh time since 1960.
But it’s not just that… Since the year 2000, the rate of monthly core PCE growth has been 0.17%. Based on that math, it implies core growth will fall to 4.2% on a year-over-year basis when the April numbers are released.
That means the central bank will soon have room to start cutting rates… or, at the very least, stop hiking.
That’s important because when interest rates start falling once more, it means the cost to borrow will drop. As that happens, the dollar will become more readily available. And fund managers will take advantage of the opportunity to lever back up and invest in risk assets like stocks.
As we said at the outset, the S&P has averaged an 8.1% annualized return over the following 24 months whenever this situation occurred in the past. Considering the index has gained 9.5% annually since 1927, these returns aren’t bad, but they aren’t earth-shaking, either.
So, we decided to study other asset classes – specifically, bonds – during the times when this trigger occurred. (We’ll explain why we went straight to the bond market in just a moment.)
And what we found there was far more compelling…
S&P On Steroids
Look at the performance of the iShares 20+ Year Treasury Fund (TLT) when this happened previously…
iShares 20+ Year Treasury Fund (TLT) Returns
The chart above shows us the month and year when the fed funds rate was higher than core PCE. It then details the gains for investors over the following three-, six-, 12-, and 24-month periods. The success rate tells us the number of instances when there was a positive result.
TLT was started in 2003, so there are only two earlier instances when this same event has taken place. An 18% one-year and 27% two-year gain far outpaces the S&P 500. That would make sense considering the central bank has room to cut rates. The change should encourage long-term investors to lock in high yields on safety assets like Treasuries before they start to drop.
A 100% success rate means investors made money both times. That’s not a huge number of instances, and it doesn’t mean you’re guaranteed to make money again, but it does suggest the odds are in your favor.
And now, core PCE numbers are back below the effective federal funds rate for only the seventh time since economists began tracking the data.
That will trigger the buy signal no one sees coming. And for astute investors, that means an opportunity to pounce and grow their long-term wealth by buying U.S. Treasury bonds. Here’s why.
Time to Buy Bonds
If the central bank is ending rate hikes, that means we’re reaching peak interest rates. And if you’re a bond investor, that’s a huge deal… because, if the coupon payment on sovereign debt isn’t going higher, soon you won’t be able to lock in today’s high yield.
Remember, bonds and yields have an inverse relationship. When everyone is selling bonds and prices drop, yields go up. For instance, let’s say you owned a bond at $100 paying $5 in interest. In that case it’s yielding 5%. But, if the underlying price drops to say $90, anyone buying at that price would receive a 5.6% yield.
Conversely, think about what happens when everyone wants to buy that same bond. Let’s say the underlying price increased from $100 to $110. The bond’s yield has suddenly dropped to 4.5%. Again, the coupon payment hasn’t changed but anyone who purchases it at a higher price will see a diminished yield.
And that’s exactly what we think is going to play out in the Treasury markets. With the Fed not raising interest rates, institutional investors will race to lock in peak yields on an asset class that is considered one of the safest in the world. After all, 10-year U.S. Treasuries are yielding about 3.4% currently compared to the S&P 500 Index’s dividend yield of 1.7%.
Based on the outcomes for stocks and bonds that we’ve previously discussed, we’ve identified two opportunities that we think are worth considering.
The first is a capital appreciation trade for investors with a high risk tolerance. We think they can see steady long-term gains in the investment we’re about to recommend.
The second is an income idea for investors with less risk tolerance. We think this idea will allow them to gain exposure to both an income stream as well as asset appreciation potential.
Now, if you want, you can purchase U.S. debt directly from the Treasury Department via the TreasuryDirect system. Opening an account takes around 10 minutes. Or we can invest in the next closest thing… exchange traded funds (ETFs) that buy U.S. Treasury bonds.
Trade Opportunity #1
And that leads us to our first idea… we think there’s an excellent opportunity for investors with a high risk tolerance to make capital gains in the PIMCO 25+ Year Zero Coupon U.S. Treasury Fund (NYSE: ZROZ). We want to use a buy-up-to price of $92 and a trailing stop of 15%.
The fund was launched in late 2009. Its assets are invested in 25 different Treasuries of varying maturities. It pays income distributions on a quarterly basis and currently has a 2.1% yield. It’s designed to mimic the total return of the BofA Merrill Lynch Long U.S. Treasury STRIPS Index.
STRIPS are Treasury bonds where the principal and interest payments are “stripped” out into smaller assets, paying out at maturity. For instance, a 10-year Treasury that pays 20 coupons over its lifetime will become 21 smaller bonds – 20 bonds that mature with each interest payment and one when the principal is repaid.
STRIPS tend to trade at a discount in the open market. Like other bonds, rising interest rates are a headwind while falling rates are a tailwind. And because this particular investment trades at a discount to face value, it’s regarded as zero-coupon.
As you can see in the above chart, the end of the Fed’s last rate hike cycle in late 2018 was a huge tailwind for ZROZ. From the time of the last hike in December 2018 to the peak in March 2020, when rates were slashed to 0%, the stock took off. It ran from $112.49 to $189.98. That’s a gain of 73% on a total return basis (dividends reinvested) or 58% annualized.
And look at what happened the last time the rate of core PCE growth fell below the effective fed funds rate in 2018…
PIMCO 25+ Year Zero Coupon U.S. Treasury Fund (ZROZ) Returns
But the price has been under steady pressure ever since the 2020 peak. Once investors realized interest rates had nowhere to go but up, they decided better returns were to be had elsewhere. From the peak in March 2020 through the start of May, the ETF has dropped 49.1% on a total return basis or 19.3% annualized.
Yet the environment is turning again. Because we think the Fed is at the end of the rate hike cycle, interest rates likely have nowhere to go but down. It won’t happen tomorrow, but it could happen as soon as the end of this year. And that means ZROZ is poised for big gains.
And that brings us to our second idea…
Trade Opportunity #2
There’s an excellent opportunity for income-seeking investors in the iShares 0-3 Month U.S. Treasury Bond Fund (NYSE: SGOV).
The fund was launched in January 2020. It wasn’t around the last time our trigger took place, so we don’t have historical data. But, as we said, we see an opportunity for the steady income being generated by the current level of rates.
You see, this fund buys Treasuries that mature in 3 months or less. That means the underlying price is relatively stable as the bonds mature rather quickly. More importantly, it has a net indicated yield of 4.7% and pays out a monthly income distribution.
Now, you may notice that as we move further out on the above chart, it appears as if asset volatility has increased. However, that’s not the case (note that the price has fluctuated between $100 and $100.50/share). You see, back in 2020 and 2021, bond yields were lower. So the payouts weren’t as great. But, as the central bank began raising interest rates, those payments went up. And because SGOV invests in bonds that mature within three months’ time, the distributions rose as well.
As more investors purchased the ETF for the income payout, the price went up. But each time a monthly income distribution is made, the value of the ETF drops to reflect the payout to investors. As a result, we should expect a similar reset every month.
For investors seeking the safety of steady income without a lot of risk, we think this is an excellent way to add stability to your portfolio. It’s also an excellent time to lock in yield.
Already, we’re seeing signs of declining economic activity. As we mentioned before, inflation growth is slowing. In addition, first-quarter economic data showed 1.1% growth compared to 2.6% in the fourth quarter. Both of those are what the central bank seeks through its recent rate hikes. And given time, the slowdown will lead to rate cuts.
Or if the economic environment were to significantly deteriorate, U.S. Treasuries would see incremental safe-haven demand.
But as we said previously, with the Fed not raising interest rates, institutional investors will race to lock in peak yields on an asset class that is considered one of the safest in the world. And as demand starts to overwhelm supply, it will drive bond prices even higher, rewarding steady long-term investors who take advantage of the opportunity now.
That is why we think now is the time to take advantage of these opportunities who investors seeking both capital and income returns via one of the safest investments in the world. Because once the central bank starts cutting rates once more, the opportunity will be gone. We’ll be tracking each of these opportunities in our portfolio and will keep you updated on our thesis and how our recommendations are performing.
Porter & Co.
Stevenson, MD