TLT And The QT Nothing Burger

One of the reasons macroeconomics is so fraught is because the level of ignorance amongst even people who are professionals is very high. I've had conversations with economists who've never heard of the "Eurodollar system", for instance. I've had conversations with analysts who remain of the view that the Fed "prints money" as opposed to bank reserves. In my view, if ignorant people make decisions based on faulty logic, the market will skew from the rational for a while. This is tiresome in some ways, but it's also the source of profits. Although the emotional cost of waiting is high, knowing that you're trading against people who seem unaware offers some comfort. That's my perspective, and I think it's worthwhile mentioning that at the beginning of this article to give you some sense of my biases. I am also very comfortable acknowledging my ignorance about the global monetary system, because it is actually a very complex, often murky set of systems. Given this, I try to base my thinking on history. Specifically, I think price history is helpful because it gives us insight into the countless bits of information that no one individual has the capacity to grasp. Specifically, the clearing price of a given set of trades aggregates the tug-of-war between buyers and sellers. The level at which these trades settle offers insight into the global financial system at a given point in time that would be otherwise impossible. Additionally, price history helps us test our narratives, and, hopefully, gives us the tools necessary to burn away some of our faulty assumptions.

In this article, I'm going to take a short survey of two periods of economic history that are relevant to a thesis on long-dated Treasuries (NASDAQ:TLT). The first of these surveys will be the last time TLT was priced at current levels, June 2007. The second of these will be the one and only prior bout of quantitative tightening that ran from October 2017 to September 2019.

I know my writing can be a bit "tough to take." Additionally, we're on the cusp of the weekend, so I'm sure you have much more interesting things to do than read my take on the Treasury market. Do you go up in the hot air balloon this weekend, or do you finalise plans for your Amazonian tour? Or are you just going to chill with the supermodel of the week? These and other things are taking your attention, so time is limited. Given that my readers have limited time, I put a "thesis statement" paragraph very near the beginning of each of my articles. This thesis statement gives you a bit more than what you'd get from bullet points and a title, but much less than what you get in an entire 1,900-word screed. You're welcome. The two periods of history that I review in this article give me confidence that TLT will rise in price from current levels, and for that reason, I'll be buying the ETF today. I can't predict when it will happen, but the weight of probabilities is such that I'm confident that the asset is currently on sale. In any event, I'm comfortable clipping a nice 3.5% yield while I wait for reality to reassert itself. This ends my thesis statement. I look forward to reading any alternate points of view in the comments section below. Given the nature of the internet, I am very confident that any alternative point of view will be expressed in a mature and thoughtful manner.

History As Guide

As I sit here, staring out at a depressingly cold Toronto day, TLT is changing hands at $88. This is a relatively low price, and you might ask "when was the last time this thing traded at that price?", to which I would answer "I'm glad you asked me that, my rhetorically convenient friend, as knowing that would be helpful." It turns out that TLT last traded hands at this rate in early June of 2007. I thought it would be interesting to include a news article from the period to see what market participants were saying at the time, so I included a news article from the period to see what market participants were saying.

For those not interested in clicking the link above, here are the highlights from this article.

1. 10-year Treasury yields jumped above 5%, and the 30-year leaped too amidst worries about rising inflation, and rising rates.

2. Bill Gross, whom the article referred to as a "bond guru", turned bearish on the treasury market.

3. Stocks sank amidst worries about rising financing costs.

The mood at the time was shock because the hoped-for interest rate cut was likely off the table because "the economy hit a sweet spot." To remind investors, this was June of 2007. When a flurry of upbeat readings on the services sector, the job market, pointed to a pickup in the economy. June. 2007. In case you're not a history buff, I think it might be worth reminding you that June of 2007 may not have been a great time to invest.

Also, in case you were wondering if Bill Gross's bearish bond bias was justified, TLT was trading in the mid-$80s when Mr. Gross decided to turn bearish. Within a year, TLT was up 8%. Within five years it was up 47%. I could go on, but you get the picture.

This episode reminds me of a quip I heard years ago, and it goes something like "be greedy when others are fearful and fearful when others are greedy." Given what's gone on with the price of TLT over the past year, I'd say that the market is pretty fearful at the moment.

Who's Afraid of Quantitative Tightening?

Some people fear the impact of quantitative tightening on TLT's price. Here is my understanding of their thinking, and if I am missing something, please fill me in in the comments section below. The Fed needs to engage in QT because it is an effective inflation-fighting tool. When the Fed allows long-dated bonds to roll off, then surely the price of long-dated bonds will crash. On the face of it, this narrative makes some intuitive sense. The assumption undergirding this is that yields on long-dated Treasuries have been kept artificially low because of the Herculean efforts of the Fed. Any let-up in those efforts will send yields soaring skyward.

I'm going to review the first of these assumptions now: namely, that QT must be engaged in because it's an effective inflation-fighting tool. To get at this one, I think it would be helpful to read what the Federal Reserve itself thinks of the impact of quantitative tightening on rates, since that is a central thrust of the bearish thesis here. We see from the following that the Fed itself is suggesting that a $2.2 trillion roll off of Treasury securities is equivalent to 29 basis points. You can't make this stuff up. The Fed itself is suggesting that QT is such a squib that it's only the equivalent of a shade over a quarter of a point?! Given that the Fed itself acknowledges that QT is not particularly effective, I think it reasonable to question their commitment to the policy.

It's now time to write about the second assumption, namely, that when The Fed allows long-dated bonds to roll off, their price will crash. I think this worldview was eloquently expressed in an article recently published on this site. From the article:

"When conducting the QE, the two central banks (ECB, and the Fed) expanded their balance sheets by buying government, corporate, and mortgage backed bonds in the open market, which pushed the long-term rates to record lows."

I am not trying to single out this particular author, I could have very well picked any number of articles with a similar view. But I have a hard time trusting mechanistic language like "x causes y" when it comes to a system as complex as the modern global financial system. Is QE alone the reason why long-term rates have been so low for so long? In my view, simple cause effect relationships are few and far between, particularly in global finance. That's just what my gut is telling me, though. I think it would be helpful to review history once again to see how previous QTs have impacted the market. For very obvious reasons, there aren't many historical precedents, but, thankfully we've all experienced one bout of quantitative tightening.

The Quantitative Tightening Nothing Burger

I'll set the stage by reviewing the timeline briefly. In October 2017, the "Balance Sheet Normalization Program" (i.e., QT) began. The initial figure was $6 billion per month of Treasuries that were allowed to mature and roll off the balance sheet. This figure increased by $6 billion per month until it reached a roll off of $30 billion per month in October 2018. Six months later, the FOMC announced that it would reduce the level of Treasuries running off the balance sheet from $30 billion to $15 billion, beginning in May 2019. A few short months after that, on July 31, 2019, the FOMC announced that it would end the runoff of the Fed's balance sheet earlier than previously indicated. So, the whole QT program lasted 24 months and varied in size over that time span.

For those who prefer pictures, feast your eyes 'pon the following:

So, "quantitative tightening" lasted from October 2017 to September 2019. You may be wondering what impact this quantitative tightening business had on TLT. If you found yourself wondering that, then wonder no longer, because I looked it up for you. I did this because I've got an absolutely obsessive need to scratch my reader's intellectual itches. Feast your eyes on TLT's price performance during the era of quantitative tightening:

For those who prefer numbers to pictures, on October 1st, 2017, TLT was priced at $123.59. On October 29, 2018, it hit a nadir price of $112, a drop of about 9.4%. From that slough of despond, it climbed to a price of $169.74, about 51.5% from the lows, and 37% from the time quantitative tightening was initiated.

The only time that we ever initiated quantitative tightening, TLT moved around a bit, but it hardly cratered. I've been asked in private conversation about whether I think this price performance will repeat over the current batch of quantitative tightening? In my view, no, for a few very simple reasons. First, the world today is very obviously different from what it was in 2019. The numbers are bigger, for instance. Additionally, the world today is even more crisis-prone, which is TLT bullish. Second, history never repeats, it merely rhymes.

I'm going to need you to indulge me as I jump up on one of my many soapboxes. In my view, the obsession with what central bankers do or don't do is a smokescreen. In my opinion, the narratives presented by central bankers, echoed by much of the media, is, to borrow from Shakespeare, "a tale told by an idiot, full of sound and fury, signifying nothing." Their own study demonstrates that colossal quantitative tightening has little effect on rates, and therefore inflation, so why do we continue to pay attention to these bureaucrats?

In conclusion, I think the decision to buy TLT or not comes down to your views about the current state of economic health. Is inflation going to linger? Can governments, corporations, and households continue to tolerate interest rates at current levels? In my view, the answer to both of these questions is "no", and for that reason, I'll be buying more TLT. I don't know when, but I think it's going to rise in price from here. I think that because I've reviewed the most relevant history here. I can't predict when TLT will spike from here, but in the meantime, I'm very comfortable collecting a 3.5% income stream from the investment.