TLT ETF: Federal Reserve Tapering May Cause Large Bond Crash (NASDAQ:TLT) (2024)

Interest rates have been on a general declining trend since the 1980s as the "Great Moderation" era has led to greater price stability. However, since last year, it seems this era may have come to an end. Inflation is currently near the highest levels since the 1980s as goods and labor shortages have returned. This follows a multi-decade "general glut" that was fueled by rising automation, labor outsourcing, and improved global trade relations. Today, these trends have waned as countries worldwide struggle with immense energy shortages, food shortages, and trade difficulties.

Likely, the U.S. Federal Reserve policy (and similar in peer nations) of quantitative easing and zero interest rates have also contributed to higher inflation. If it were not for immense stimulus last year from global central banks, demand for goods would have likely plummeted, and there may not have been the goods shortages we see today. That said, hardly controllable issues such as low energy production and investment and an immense blue-collar labor shortage will contribute to higher inflation regardless of monetary policies. Unfortunately for the Federal Reserve, energy, workers, and food cannot be printed.

Oil is still the lifeblood of the global economy as what happens in the oil market affects prices throughout the world. This is illustrated by the strong inverse relationship between U.S. crude oil stocks (oil storage levels) and the inflation breakeven rate. See below:

As you can see, periods with high oil storage levels generally have lower expected forward inflation during periods of low storage high higher expected inflation. Today, oil storage levels are very near a decade low and will likely continue to decline following OPEC's recent decision to keep oil production at depressed levels. The fact of the matter is that, unless there is a severe decline in economic demand (i.e., a significant recession), inflation is likely to continue to remain high despite impending Federal Reserve tapering.

Despite high inflation, long-term interest rates are still near very low historical levels. In my view, this is because Q.E. creates significant artificial demand for sovereign bonds. While I expect inflation to remain high, the Federal Reserve is expected to stop purchasing these bonds over the coming months. Accordingly, this may lead to a significant increase in long-term interest rates, which may make for a short opportunity for ETFs like NASDAQ:TLT. Let's take a closer look.

Beware Of Positive Stock-Bond Correlation

The ETF TLT is a popular instrument that investors and asset managers use to gain exposure to the 20+ year Treasury Bond market. The fund has had solid risk-adjusted returns since its inception as long-term interest rates declined. Additionally, TLT normally rises as stocks fall, making the fund a historically great way for investors to lower portfolio volatility. That said, TLT is far from a low-risk investment in the current market regime.

Today's "market regime" has been highly uncommon in recent history, though it is not necessarily uncommon if we look to decades before the "great moderation" began. That is, a stagflationary economic environment marked by muted demand and volatile supply. Economic supply is far more critical than demand in this situation, as shortages lead to higher costs and lower corporate margins. This differs from the 2000 and 2008 recessions that saw economic demand decline below supply - causing immense disinflation that boosted sovereign bonds. In today's environment, rising prices may lead to a synchronized decline in corporate profit margins and sovereign bonds (as interest rates usually track inflation).

This shift can be seen quite clearly in the positive correlation between monthly returns in the S&P 500 ETF (SPY) and TLT:

Typically, TLT (long-term Treasury bonds) and SPY (stocks) have a negative correlation. However, this is only true when changes in economic demand are driving markets. When supply issues lead to higher inflation, stocks and bonds can become correlated. Today, TLT and SPY see the highest correlation since their inception, practically killing the effectiveness of "60/40" or "risk-parity" portfolio strategies. Put simply, TLT is no longer a means of lowering portfolio volatility.

Tapering To Lead to A Spike In Rates

While TLT does not currently offer material volatility reduction, it may also be in the initial phase of another sharp decline. The fund now has a 2.1% yield-to-maturity, giving it a -0.4% real return after accounting for expected inflation. Since rates are so low and it has a ~26-year maturity, TLT has an effective duration of ~19 years. Duration is an important figure that tells investors how many years it will take to recoup losses given a 1% rise in interest rates. Today, if long-term rates were to rise just 1%, TLT's value is expected to decline around 19%.

I believe we may see such a move over the coming months as the Federal Reserve slows its asset purchases. 20 year Treasury bonds currently have a ~2.08% yield, representing a -0.41% real yield after accounting for expected inflation. Rising inflation has led to a rise in the 20-year rate over the past year, but immense Federal Reserve purchases of these bonds have kept their real yield (return after inflation) at record lows. See below:

Without ~$2.5T in purchases from the Federal Reserve, I do not believe 20-year real yields would be as low as they are today. There has been extremely low demand for Treasury bonds from private entities like households and global investors such as there was in the 2008-2010 period. Instead, almost all of the recent demand for Treasuries has been primarily from the Federal Reserve and secondarily from banks. Soon, the Federal Reserve is likely to stop purchasing these bonds. Commercial banks have already slowed purchases as the Fed discontinued a pandemic rule-change that encouraged Treasury bond investments by not counting them in risk assessment.

The truth is that most of the demand for Treasury bonds since 2020 has been artificial, either from Q.E. or from banking rule changes made to ensure deficit funding. Indeed, it is highly illogical for private investors to fund a massive government deficit to a country with a likely unpayable debt-to-GDP level for a negative real return. This is particularly true considering the genuine possibility of default by December.

At the very least, I expect the coming end to Q.E. to result in normalization in the real yields on long-term Treasury bonds back to the historical average range of 0% to 1%. In other words, I do not expect private demand for Treasury bonds to rise to necessary levels until 20-year rates rise to around 2.7% to 3.5% (a 0.6% to 1.4% increase from today's levels). This is based on no expected changes to the inflation outlook though rates could rise higher if shortages continue to push the inflation outlook higher.

A Short Opportunity

If long-term Treasury rates rise to the 2.7% to 3.5% range, then TLT should decline in value by 11% to 27% based on its current duration level. We saw an initial decline in TLT early this year as inflation spiked, but its real return remained low due to Federal Reserve long-term bond purchases. Recently, TLT has taken another dive as tapering draws near. See below:

In my view, TLT's drop is only getting started and is a great short opportunity. The current borrowing cost of TLT is around 1% today, making for a ~3% total annual carry cost after accounting for its dividends. In my opinion, this is a small price for an expected 11-25% decline in TLT's value.

Of course, there are risks in betting against long-term Treasury bonds. The primary bearish factor facing TLT is impending Federal Reserve tapering. While I believe this tapering is highly likely, the recent wave of negative economic factors (see dismal jobs report) may delay tapering. It is also possible that these negative trends cause a decline in demand for goods sufficient to cause inflation to reverse. Either of these occurrences would likely result in interest rates remaining lower-for-longer. It seems most likely that the Federal Reserve will remain true to its stated plans unless there is a significant decline in the stock market (which is not necessarily unlikely).

That said, I am firmly bearish on TLT for the time being and believe the fund may decline without a rise in the stock market due to their positive correlation today. The fund is highly liquid and accessible to short, but investors who do not wish to short TLT outright can use an inverse ETF like TBF or the levered TBT to magnify the trade.

Harrison is a financial analyst who has been writing on Seeking Alpha since 2018 and has closely followed the market for over a decade. He has professional experience in the private equity, real estate, and economic research industry. Harrison also has an academic background in financial econometrics, economic forecasting, and global monetary economics.