The Big Short Elephant In The Room – One Fund Manager’s Big Short For 2021
2020 will go down in history as a historic year, on and off Wall Street. In the aftermath of Covid-19, global central banks, led by the Federal Reserve, took rates to zero and flooded the system with even more liquidity to help stabilize the global financial system. So far, the plan is working because “asset prices” soared, led by the U.S. stock market, and the economy rebounded nicely after the sharp contraction we saw earlier in the year. However, one area, long-term treasury rates, are one fund manager’s big short for 2021. I spoke to Jay D. Hatfield, Portfolio Manager at Virtus InfraCap US Preferred Stock ETF PFFA with over $500 million in assets under management and here are his reasons why long-term treasury rates are his big short for 2021.
Misconception About What The Fed’s Pledge To Keep Rates Low:
Many investors have assumed that the Federal Reserve’s pledge to keep interest rates low through 2023 applies not only to the Federal Funds rate, but also to long-term interest rates. As a result of this misconception, most investors are not positioned for a significant increase in long-term treasury rates. This is a big problem because many investors are adding to mortgage and other investment grade assets without any concern for what may go wrong.
10-Year Treasure Rate & Inflation:
Another big piece of Jay’s thesis is that he believes there is a big disconnect between the 10-year Treasury rate and inflation. The 10-year treasury rate has traded at an average of 2.5% over the inflation rate since 1960 and the 10-year rate has only traded below the inflation rate for 22 months over the last 60 years (excluding the Pandemic). That said, if you further analyze the relationship between the 10-year Treasury Rate and inflation you will see that there is a 70% correlation between the 10-year rate and the inflation rate over the last 60 years. With the current core PCE rate at 1.4% and the Fed targeting a rate well above 2%, it would be expected that the 10-year treasury rate will trade up by at least 0.70% by the end of 2021. That is a very important point because that is something that most people on Wall Street are not paying attention to right now.
Do Not Underestimate the Power Of The U.S. Consumer:
Jay believes the economy will grow sharply in 2021 and that will put pressure on the Fed to reduce stimulus going forward which is why he is bearish on long-term treasury rates. Since the beginning of the Pandemic, economic forecasters have underestimated the speed of the economic recovery. Jay believes that economists have underestimated the power of low interest rates to stimulate the housing sector and focused too much on the impact of the Pandemic on the travel and leisure sector. The housing market drives consumer spending on consumer durables and impacts consumer confidence which is a big component of gross domestic product (GDP).
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Fed Will Slow Down Or Halt QE:
Jay also believes that there are several forces at work that may lead the Fed to slow down or halt its QE efforts going forward. First, let’s look at the economy. 2020’s 2nd quarter GDP growth was 33% and the 4th quarter is tracking at approximately 11%. Looking forward, the virus will likely be contained by the distribution of vaccines in the first half of 2021. If that happens, the economy should rebound nicely and we should see the economy grow at over 6% in 2021. If the economy grows at over 6% in 2021, inflation will likely pick up and that that will cause the Fed to cut back or halt quantitative easing which will put upward pressure on long term interest rates.
Back To Normal:
Another important point is that after the virus is contained, the Fed will likely slow its $80 billion of monthly purchases of treasuries and mortgages, or to cease such purchases entirely. This will likely put significant upward pressure on long-term treasury rates.
There are approximately 225 million adults over the age of 25 in the U.S., at least 25 million of which have already contracted COVID-19. Thanks to the anticipated distribution of vaccinations soon, the US is well-positioned to contain the spread of the virus in the first half of 2021.
Furthermore, the 2020 budget deficit is running at approximately $2.7 trillion, compared to a $1 trillion deficit in 2019. With an incoming democratic administration focused on stimulus and infrastructure spending, the 2021 budget deficit could easily reach $1.5-$2 trillion and would likely not be monetized by the Fed in the second half of the year.
As a result of the combination of highly stimulative monetary and fiscal policy, Jay believes that the US economy is likely to grow by at least 6% in 2021, with the resolution of the Pandemic leading to a surge of leisure travel during the summer as pent-up demand hits the market.
With 10-year treasuries currently near all-time lows at approximately .95%, Jay sees significant risk that the 10-year trades into the 1.5-2% range as the year progresses. This very significant risk of a potential rise in long-term rates indicates that investors should reduce exposure to investment grade bonds and mortgages and rotate into high-yield bonds and preferred stocks. In a rising rate environment, financials and other cyclical sectors are likely to outperform technology, housing, and defensive sectors such as consumer durables, healthcare, and utilities.
Jay told me, “These circumstances set up what we believe will be the “big short of 2021” – long-term treasuries. We believe this to be an extraordinary short opportunity because, like the prospect of shorting residential mortgages in 2006 and 2007 at low spreads to treasuries. With 10-year treasury rates at historic lows, currently below 1.0%, we believe there is limited downside.”
The one big lesson we learned in 2020 is that anything can happen at anytime. We also learned that the U.S. consumer is resilient, and the Fed really wants inflation to pick up. After all, in late 2020, the Fed changed its stance and said it wants inflation to be around 2% before it starts raising rates. That is a big difference from where the Fed stood on inflation before the pandemic. For all of these reasons, Jay believes long-term Treasury rates will be a big short for 2021.