ZROZ ETF

Despite recent volatility, I maintain a "Buy" rating on the ZROZ ETF as a recession hedge, given the uncertain economic outlook. Higher implied premiums may lead to worse performance of long-term US treasuries in a soft landing scenario. Potential downward revisions in non-farm payrolls data suggest long-term US Treasuries may see a sharp rally in early 2025.

The PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF tracks long-dated US government STRIPS, giving it increased interest rate sensitivity. The current 4.5% yield on long-dated US treasuries is well above the Fed's neutral rate and should deliver higher returns relative to the short end of the curve. A 4.5% nominal annual return for 25-30 years will likely lag behind riskier alternatives such as equities or real estate.

ZROZ ETF is a long-term zero-coupon bond vehicle managed by PIMCO, which has shed nearly 15% of its value in the past year. We believe the volatile interest rate environment makes this long-duration bond vehicle unattractive. A rising term premium and liquidity worries might dampen ZROZ's pricing and dividend-based prospects.

Long-term Treasury ETFs like ZROZ have the potential to outperform equities and commodities due to a disinflationary downcycle and a significant decline in yields. The behavior of the yield curve suggests that long-term yields will fall over the course of the next two years, benefiting long-duration Treasuries. Relative performance metrics currently show underperformance of ZROZ, but it will likely beat the S&P 500 and commodity ETFs as yields fall.

The Federal Reserve will likely cut rates this year. Significant rate cuts would almost certainly lead to higher bond prices. Most bond funds would benefit, some more than others. ZROZ would be one of the biggest beneficiaries.

The bear market in bonds has ended and long-duration assets are rallying, presenting an opportunity for capital gains. The Federal Reserve's interest rate hikes have negatively impacted the bond market, leading to losses in fixed income assets. I predict that inflation will normalize and the Fed will eventually cut rates, leading to potential gains in the ZROZ bond fund.

We challenge the view that interest rate normalization accompanied by a Fed pivot will drive down ultra-long-term yields. Low long-term yields are an illusion created by the effects of quantitative easing, and they are unlikely to repeat. We think there is room for long-term yields to rise. We see the scenario for a gradual normalization of monetary policy and the unwinding of the Fed's quantitative easing program to drive long-term yields closer to 5.5% over time.