Treasury yields have plunged over the last 12 months. What's next?

At the end of January 2019, the 10-year treasury yield stood at roughly 2.7%.  Fast forward 12 months later, and the 10-year yield has dropped to below 1.5%.  In other words, this is a 44% collapse in one year which helped usher in an epic bond rally.  Having just occurred, how does this dive in the 10-year yield compare to past periods and what does this reveal about the likely path forward in long-term rates?  Looking back to 1963, this posts will review other times where the 10-year treasury rate rose or declined by at least 20% on a year-over-year basis (monthly closing basis).  Doing so will hopefully provide context as to how far long-term rates have dropped in such a relatively short period of time.

(*The blue line is the 12-month rate-of-change of the 10-year treasury yield while the black line is the absolute level.  The dotted red and green lines are the +20% and -20% year-over-year (YOY) thresholds that will be used throughout this post.)

1963-1979

• Unsurprisingly given the secular bull market in treasury yields, from 1963 to 1979 the 10-year yield experienced four major +20% spikes and one +20% decline.  Although the August 1966 and March-May 1968 yield surges did eventually mark multi-month tops, it was not until the June 1969 - May 1970 episode that eventually resulted in a recession and collapse in long-term rates.  By the first quarter of 1971, long term rates had fallen by over 20% on a year-over-year basis.
• 1971's 22% drop eventually resulted in a decade low in the 10-year yield as they began to climb once again.  As the prior recession faded, treasury bond yields rose by the 20% threshold once more in June 1973.  Similarly to 1966 and 1968, yields did top but only briefly as inflation surged once more between 1973 to 1975.  With the US in its second recession of the decade, the 1973 spike proved to be a helpful precursor.  
  
• To recap, August 1966, March-May 1968, June 1969 - May 1970, and June 1973 all saw yields rise by at least 20% within a year.  Each marked intermediate term tops in long-term rates with the 1970 & 1973 leading to recessions.  The only 20% YOY decline in the 10-year yield came in Q1 1971.  This proved to be a great time to sell bonds as yields soon bottomed with inflation picking up.

1980-1999

• The 1980s began the way the 1970s ended.  By March 1980, bond yields had soared by nearly 39% in twelve months.  This lead to the first recession of the decade and a multi-month rebound in treasury bond prices.
• However, this rebound in bond prices proved to be very short-lived as yields would go on to surpass the 20% threshold by April 1981.  By September of that year, long-term rates had increased by a whopping 33%.  This provided investors with another great opportunity to buy treasuries ahead of the second downturn of the 1980s.  
• Indeed, the massive jump in yields in the first half of 1981 kicked off a bull market in bonds that culminated in a YOY 27% drop in the 10-year rate in October 1982.  Such a decline in yields within twelve month again proved to be a great indicator that a bottom was near.  
• For the rest of the 1980s and 1990s, bond prices experienced a secular bull market.  Despite that, yields would spike by greater than 20% on four further occasions (Q2 1984, the 2nd half of 1987, June 1994 - Jan 1995, August 1999 - February 2000).  Each episode helped kick off multi-year cyclical bond bull markets.
• Alternatively, yields fell drastically in 1986 (-36% YOY), 1993 (-20%) Q4 1995 (-28%), September 1998 (-27%).  These big declines of over 20% in bond rates all lead to major bottoms.
• Thus. the key takeaway from the 1980s & 1990s was similar to the prior two decades  Big annual increases in yields provided great buying opportunities in bonds with the opposite being true following large YOY declines in long-term rates.
  

2000-Present

• From September 1999 until February 2000, the 10-year treasury rate had increased on average by 30% relative to a year earlier.  Again, investors were given another chance to buy bonds ahead of a multi-year bull market that ended in May 2003.
• This pattern would continue where YOY interest rate surges of 20% or greater in April-June 2006, December - March 2010, May 2013 - April 2014, January 2017 - November 2018, were all eventually reversed.
• On the other hand, bond prices topped in December 2002 - June 2003, March 2008 - March 2009,  November 2011- August 2012, June - September 2016 following +20% YOY drops in long term interest rates.  
• This brings us to the present.  Starting in May 2019, the twelve month decline in the 10-year rate surpassed -20%.  By August 2019, the 10-year yield was 47% lower than it was a year earlier.
• If history is to be a guide, a decline of this magnitude in long-term yields should provide investors with a great selling opportunity in treasury bonds.
• Also, it should be noted that this ongoing post-Global Financial Crisis era has seen market participants witness massive swings in yields (rate volatility).  It was just recently in Q4 2018 where the 10-year yield stood at 3.1% only to collapse below 1.5% by September 2019.  
• At the end of 2018 with yields surpassing 3%, notable market participants were calling for 6% in the 10-year bond. With sentiment having swung to an extreme in the other direction following a 45% plunge in the 10-year rate, has treasury bond bullishness gone too far?

Despite that, treasuries are in a downtrend but the risk-reward is not favorable.

All the above speaks to the historical risk-reward picture currently being offered by treasury bonds.  Simply put, such drastic declines in yields over a 12-month period tend to precede at least multi-month lows and in certain cases multi-year cyclical bottoms.  This has been true even during this ongoing multi-decade march lower in rates that kicked off at the start of the 1980s.  Therefore, yields may certainly keep declining into possibly negative territory, but they are unlikely to do so without major rebounds along the way.

With that said, the downtrend in yields that began in Q4 2018 is still intact.  Until that ceases, betting against bonds is not prudent yet.  Trends can go to greater extremes before eventually reversing themselves.  However, when this trend does end, global investors will have been given an opportune time to sell bonds that have greatly appreciated in value.  From a bond & debt issuers point of view, markets are providing them with the chance to issue long duration fixed income securities at yields that are materially lower than they were 12 & 18 months ago.  This is particularly true for develop market sovereigns.  Importantly, unlike scenarios where risk-off is dominating the move in long term rates, credit spreads remain tight.

• As seen above, from a multi-year perspective the 10-year yield has been ranged bounce between 3% and 1.4% since the Eurozone Debt Crisis.  Will 1.4% hold (on a monthly close) as it did in 2012 & 2016 or are yields set to definitely break below this support level?  This is to be determined and bears very close monitoring.  

• From an intermediate term perspective, the 10-year yield has been in a downtrend since the end of 2018.  This remains in place and must be respected for the time being.

• Although fixed income securities have rallied sharply since Q4 2018, US equity indices (S&P 500) have outperformed bonds (VBMFX - Vanguard Total Bond Market Index Fund) starting at the end of 2019.  This is a very similar set up to 2009/2010, 2012/13, and 2016 all of which lead to multi-year uptrends in US equities.

• From the end of January 2018 to the end of October 2019, US equity indices consolidated for roughly 19 months.
• The characteristics heading into and following December 2018 are consistent with prior cyclical bottoms.  
• In this light, the price action since the start of November 2019 appears to be a breakout in a new cyclical uptrend.  A weekly close below levels around 317 - 309 in the SPY would cause this writer to begin to take defensive actions.  Until then, the trend in US equities is up with the expectation of normal corrections along the way. 

Conclusion:

Over the course of the last 12-months, the 10-year treasury yield has fallen by greater than 45% which is a historically significant move lower.  This has come in backdrop where,

• credit spreads remain tight, 
• inflation and inflation expectations are below target and subdued,
• oil and commodity prices are stuck in a secular bear market,
• VIX and VIX products are trending lower
• US equity indices have begun to outperform bonds,
• the Fed has signaled that the bar for a rate hike is very high (lower for longer).

Unless this configuration changes (volatility begins to rise materially along with credit spreads and the Fed becomes hawkish), US equities should be favored over long duration fixed income.  To summarize, the set of conditions listed above are usually associated with an environment that is beneficial to risk assets over the intermediate (months) to long term (years).  Arguably, we are reaching a point where is it better to issue long term debt than to hold duration.