TLT: Watch Out Below If Bond ‘Support Wall’ Cracks (NASDAQ:TLT)

Thus far, 2022 has started as a relatively volatile and conflicting market. Despite massive inflows into equity funds, most stocks have been off to a rocky start. On the other hand, most commodities have continued to rise, further increasing inflationary pressures. Of course, the most exciting action has undoubtedly been in the bond market, which has experienced significant declines across the board. The long-term Treasury bond ETF (TLT), which is often seen as a risk hedge, is currently down around by double digits since December as inflation hits consecutive 40-year highs.

In October of last year, I warned investors about risks facing long-term bond funds like TLT back in “TLT: Federal Reserve Tapering May Cause A Large Bond Crash.” Since then, we have seen a relatively significant decline in bonds, with the fund now resting at a critical support level at roughly $135. Historically speaking, bonds are still “expensive” as interest rates remain relatively low despite the rise, so it would be understandable to see the fund continue to drop. Of course, so many investors today have been conditioned to buy any and all dips, so it is also reasonable to expect some resistance against further declines. See below:

In my view, the long-term bond market is at a very critical level today. Long-term Treasury rates are floating around the same critical levels as last spring and early 2020, meaning many investors likely entered positions around this level. The trends we see over the coming period will inform us of developments in fundamental market conditions. Specifically, whether or not the credit market can remain afloat without direct infusions from the Federal Reserve.

If TLT fails to bounce and crosses firmly below its current level, then I suspect it may experience a more prominent, more pronounced sell-off than we’ve seen thus far. This may have enormous implications for the rest of the financial markets since Treasury bonds underpin all global finance. Critical questions we must ask include: Whether inflation expectations will continue to rise, whether the Fed will directly sell Treasury bonds to reduce inflation, and how this volatility will likely impact the rest of the credit market. Let’s dig in.

Inflation Expectations and the Yield Curve

Firstly, it’s worth pointing out that the Federal Reserve is still inflating the economy by purchasing bonds injecting billions into the financial system. These asset purchases are supposed to end in March and may be followed by asset sales which pull cash out of the financial system and lower inflation. While rate hikes are not too crucial for long-term Treasury bonds, there also are growing calls for a more considerable 50 bps interest rate hike in March to stabilize the currency.

The bond market’s inflation outlook can be directly measured by taking the difference between Treasury interest rates and inflation-indexed Treasury rates of equivalent maturity. As detailed in “The 3 Keys To Rising Inflation And Why Rate Hikes May Not Be Enough To Stop It,” the bond market currently sees CPI inflation is around 4% over the next 12 months, significantly lower than the 7.5% we’ve seen over the past year. In the long run, the Federal Reserve typically wants inflation around 2%, but the bond market currently sees inflation averaging around 2.44% over the next two decades. This breakeven rate has been nearly constant over the past year as the rising interest rate forecast has helped keep the long-term inflation outlook in check. See below:

The 20-year inflation breakeven rate stopped rising when the yield curve started compressing last year. A robust economic growth barometer is the “yield curve” or spread between long-term and short-term interest rates. Thus, it’s understandable that the inflation outlook stopped rising, and the curve started flattening since inflation should slow if the economy does as well. Of course, the extremely rapid pace of flattening in the yield curve may signify that the economy will need to slow or decline substantially for inflation to remain in check.

TLT has benefited from the flattening yield curve since long-term rates have been rising much slower than short-term ones. Long-term interest rates are still above short-term rates, but the “20-2” spread is now at a very low historical level. This measure has not fully inverted since around 2000 and may continue to flatten over the coming weeks. That said, the “20-2” spread is unlikely to fall much more than 90 bps, so once that occurs, it will add to TLT’s downside risk since long-term rates will need to decline to match short-term rates.

Regarding the inflation outlook, it seems for now that the long term will remain at a reasonable level of around 2.4-2.5%. Of course, commodity prices have continued to rise despite the moderation in the inflation breakeven rate, so there’s some indication that the bond market could be misjudging long-term inflation. If investors’ faith in the Federal Reserve’s ability to slow inflation fades (perhaps due to rising commodities), then we could see a rapid increase in the inflation-breakeven rate that causes significant declines in TLT.

Signals From Across The Bond Market

TLT owns just the long-term subset of the U.S Treasury market, which has directly benefited tremendously from trillions in Fed purchases over the past two years. Other bonds, which have also helped from QE, such as mortgage-backed securities and corporate bonds have seen even more extreme losses. We can see this by looking at the spread between mortgage rates, corporate bond rates, and Treasury rates of equivalent maturities. As these spreads widen, it signals growing stress within credit markets. As you can see below, there has been significant widening in both the mortgage and corporate bond markets:

The BBB Option-Adjusted Spread measures the average yield on “BBB” rated bonds (the lowest rating within the “investment grade” spectrum). In my view, the sharp rise in this spread over the past three months is significant as it signals a lack of spare lending capacity to the largest segment of the U.S corporate bond market. Similarly, with the spread between mortgage and Treasury rates rising, there’s a vital sign that there’s very little private demand for these debt assets to support the market after the Fed ends its purchasing program.

In my view, the recent sharp rise in corporate and mortgage spreads is an initial sign that commercial banks have minimal spare lending capacity. This can be directly seen in the immense surge in total U.S commercial bank leverage levels:

Treasury bonds have more stable demand since their target assets are by foreign central banks, investment funds, and U.S banks. Sovereign bonds are privileged within the global banking system since, under Basel III rules, they have a risk-weighting of zero, so banks can own excess of these bonds without it harming their “CET1 ratio.” However, with monetary stimulus nearly over, banks won’t see as much easy cash as they have in recent years, so they may look to sell some Treasuries, particularly if the U.S government credit rating changes.

Stock-Bond Correlations Remain Positive

TLT currently has a yield of roughly 2.4-2.5% (based on rates today), which is still nearly negative compared to inflation, though higher than last year. In fact, if we assume the 20-year inflation breakeven rate of 2.45% is correct, then the “real yield” on TLT is roughly zero per year. This is zero, not for this year when inflation will be well above 2.45%, but for every year over the next twenty years. Of course, if inflation fails to decline as expected, then TLT’s real return would become even more negative.

TLT also currently carries an effective duration of 18.9 years, while its weighted-average maturity is 25.9 years. This implies a 1% increase in interest rates would push TLT nearly 19% lower (or it would take 18.9 years to recoup from a 1% rise in rates). Compared to most, TLT has a very high duration risk due to its lengthy maturity and low-interest rates. To make matters worse, it has a very positive and rising monthly performance correlation to the S&P 500 and a falling correlation to gold. See below:

This should dispel any idea that TLT is a “hedge against stocks.” While TLT can offer some diversification, it has a positive relationship with stocks from a monthly performance perspective. This change implies that if stocks crash, TLT may crash too. Many fund managers and investors choose TLT since the opposite usually is true, but in an inflationary dynamic, stocks and bonds can often decline together. This shift also is seen in gold which has a very weak relationship with bonds, implying gold is a much better hedge today.

The Bottom Line

When looking at long-term bond funds like TLT, the Fed’s credibility, Americans’ faith in fiat currency, and the broader stability of the U.S government’s spending are of growing importance. If you buy TLT, you’re essentially lending the government a 20-year-plus time horizon. While one can buy or sell TLT at any time, if people lose faith in the long-term fundamentals of U.S monetary and fiscal institutions, then these bonds could rapidly decline to pennies on the dollar as fewer believe the government will meet its hefty obligations.

Over the next few months, I suspect TLT will continue to decline and may soon break below its critical support level. The short-term real interest rate bonds, which I closely monitor, recently broke below their crucial support, so I suspect the long end of the curve will follow suit. The Fed will end its remaining long-term bond purchases over the coming weeks, meaning TLT will be entirely supported by existing money. In my view, these long-term bonds do not yet pay a high enough return to justify their inflation-degradation risks, so I doubt private money will support it. Indeed, given TLT is at such a critical support level, I suspect it could decline more rapidly than it has if it breaks lower as investors race to sell.