TLT ETF: A Deflationary Perfect Storm Is Brewing

I have written a lot about the risk of a deflation shock over recent months (see ‘Bonds Look Good As Deflation Scare Increasingly Likely‘), and have been adding to bond positions following recent increases in yields. While we have already seen a collapse in yields across the curve over the past few days, bonds are still attractive in this climate as deflationary pressures mount. From a supply perspective, money supply growth is in contraction and the Fed continued to shrink its balance sheet, while real interest rates remain highly positive, negatively impacting credit growth. On the demand side, risk aversion is taking hold of markets, causing a surge in the demand for cash. Together these two factors are also weighing on commodity demand. CPI is likely to print negative by mid-year. The iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT) is well placed to benefit as the Fed gets the green light to reverse its inflation fight.

The TLT ETF

The TLT holds US Treasuries of maturities of 20 years or more, with a weighted average maturity of around 26 years, effective duration of 18 years, and a current yield to maturity of 3.8%. The TLT has seen a surge in inflows over recent years and is the largest Treasury ETF on the market, with shares outstanding tripling over the past year and assets hitting USD32bn despite the collapse in Treasury prices. The expense ratio is reasonable at 0.15%.

The high duration means that the ETF tends to post strong capital gains during times of economic weakness and/or disinflation as interest rates expectations decline. Amid the heightened risks facing the US regional banking system, the Fed is likely to begin lowering rates over the coming months, which suggests this high duration will work in TLT’s favor. The yield 2s-10s UST yield spread, which was -107bps last week, has steepened by almost 50bps since the collapse of SVB, making the long-end of the curve relatively more attractive.

Deflation To Arrive By Mid-Year

Both short-term inflation drivers and structural inflation drivers are currently pointing towards an outright decline in prices. In terms of supply, M2 is down 1.7% y/y, thanks to the 6.6% contraction in the Fed’s balance sheet over the past years. Meanwhile, high real borrowing costs have started to weigh on credit growth.

This rapid tightening in monetary conditions is also putting upside pressure on money demand as asset prices decline from extreme levels. Credit spreads tend to be closely inversely correlated with inflation expectations as fears of rising default amid rising rates and economic weakness cause investors to seek safety, causing inflation pressures to decline. The most extreme example of this was during the Global Financial Crisis, where a full-scale panic caused inflation expectations as measured by inflation breakevens to collapse. We may be about to see things head in a similar direction, where panic becomes self-reinforcing, driving down asset prices and inflation expectations simultaneously.

The above dynamics are also feeding into commodity price weakness, and commodity prices tend to be a very good predictor of headline inflation over the next 3-4 months. The Bloomberg Commodity Index is down 20% y/y which is consistent with a CPI print of around zero by June/July.

No More Fed Hikes

The Fed’s hiking cycle has been extremely aggressive. I was among the many analysts who argued that the low rate period would lead to subsequent financial market instability regardless of how aggressive rates were normalized, but a 450bps increase over just 12 months is asking for trouble. Especially when considering that long-term inflation expectations have actually fallen over this period in line with the commodity price drop.

After the failure of two mid-size US banks over recent days, the markets have now spoken. Fed funds future markets are now pricing in an early end to the hiking cycle, and rates are actually expected to be 40bps below current levels by the end of 2023. Just last week the futures markets were pricing in 100bps hikes over this period. The Fed funds rate is now expected to be just 3.5% by end 2024, which makes the 3.8% yield on the TLT very appealing. Considering that 20-year breakeven inflation expectations sit at just 2.3% after the recent decline, this leaves 1.5% real returns, which is particularly attractive relative to the real GDP growth outlook. I ultimately expect real long-term rates to head back below zero as the Fed drives down interest rates in an attempt to cushion the bursting bubble that their prior loose policy helped create. At current levels of inflation expectations, this would require a 150bps decline in yields, which would suggest around 27% upside for the TLT.

Summary

There is a perfect storm of deflationary conditions brewing, with money supply in contraction and money demand surging amid rising risk aversion in financial markets. With commodity prices also continuing their decline, headline CPI looks set to fall to zero over the coming months, and the markets are now expecting the Fed’s easing cycle to begin later this year. These conditions should continue to support long-term bonds, with the TLT likely to post strong returns over the coming months and years.