The Most Challenging Bond Market in The Previous 70 Years
CAMS Weekly View from the Corner – Week ending 2/11/2022
February 14, 2022
A great nemesis to bond investors is price inflation. Bonds come with a stated interest rate for a stated amount of time known as their date to maturity. This stated interest rate for a stated period of time gives them the general label of fixed investments – meaning they are locked into the agreed upon investment terms. When the stated interest rate, say, gets swamped over by rapidly rising price inflation bond investors holding said bonds get eaten up by said price inflation. As offered in our previous edition, when the current 10 Year Treasury bond yields (effective interest rate) 2% but price inflation is rising at a 7% plus level bond holders are losing purchasing power by holding these bonds. As an aside, in previous times of notable price inflation, bonds were awarded the slang name “certificates of guaranteed confiscation” – a personal historical favorite in light of its innate accuracy. Bonds were known as this in slang because price inflation swamped over the stated interest rate and through this the “hidden tax,” i.e. price inflation, ate away any semblance of a return on investment – hence, “…….guaranteed confiscation.” What is A Bond Investor’s Recourse? With the above, when historic (say non-“transitory”) price inflation comes onto the scene it is obvious bond investors are – using the most eloquent of economic terms here – in a word, screwed. With this, what is their recourse? Using a word tapestry as an answer – sell, sell, sell! Collectively, when bond investor’s hit the sell buttons en masse, bonds go down in price and with this their yields (think interest rate) go up. As bonds continue to go down in price their yields continue to rise. This becomes the bond market’s recourse to historic price inflation. In essence, the bond market declares: “If you are going to inflate our return away we are going to run yields up via the sell buttons.” This elicits the slang name for bond investor’s during times of historic price inflation: “Bond market vigilantes.” Having their fixed investments swamped over by on-going price inflation they wreaked havoc in times past by selling profusely in order to protect themselves from the hidden tax of price inflation. Current Day This past week the latest release of the Consumer Price Index informed the citizenry (and the bond market btw) that price inflation is now registering 7 ½% – beating even elevated general consensus expectations. The continual and elevating price inflation data places the bond market evermore in a less attractive backdrop. Below we place this into a multi-decade context.
Ron Griess over at The Chart Store has placed the real yield quandary into a long-term picture. The above chart dates back to 1940 for perspective. As we have shared above, when the price inflation rate is swamping the actual interest rate of bonds this means said bonds are earning a negative real interest rate. This is known succinctly as, “real yields.” With this, we can place into context just how bad our current price inflation backdrop is relative to the current level of various bond market interest rates. In the case of the above chart, the 10 Year Treasury bond is placed under a historical microscope to get a visual on how low real yields are, not only as an absolute measure but also how long it has been since we have seen such a negative scenario for the bond market at large. Can you say – 70 years! Through the lens of our current day price inflation rate compared to the general level of interest rates (yields) within the bond market we are seeing historically low levels of real yields. This means bond investors are experiencing a multi-decade challenge in light of the relationship of price inflation to bond interest rates. Will They Go Vigilante? As shared above bond market participants were labeled as vigilantes in prior environments with such a poor backdrop for them. They sold bonds off profusely and raised yields rapidly. Try this on: How enthusiastic would you be to own a bond whereby its interest rate is tremendously under water relative to the price inflation level? It gets worse. In light of the risk of bond market participants selling in droves (in light of the above storyline) you also have to be simultaneously concerned of just that; a simultaneous sell-off in bonds whereby the value of them move lower resulting in not only a negative real interest rate but also in capital losses resulting from a continued bond market selloff. We Are All in the Fed’s Box The Federal Reserve is in a box and as citizens that leaves all of us in there with them. That is, their assuredness dating back a year ago that price inflation would be transitory had them continually printing massive amounts of money while also leaving their Fed Funds Rate at zero percent. Now, a year later, with price inflation turning out to be non-transitory and with them, to this day, continuing to print money (albeit less than a few months ago) and their Funds Rate continuing to be set at zero percent they (we) are in a quandary. If they continue to let price inflation run unaddressed we the citizenry continue to experience wage rates that are already negative and yet will get evermore consumed by said inflation and also, pertinent to this edition, risk losing the bond market and inviting the aforementioned bond market vigilante experience. Do you think the stock market (for example) could handle the bond market giving a “no confidence vote” on the FED via a true bond market selloff? Conversely, if the Fed realizes they need to play catch up fast by immediately hitting the off button on the printing press and simultaneously raising their Fed Funds Rate rapidly they risk a tremendous selloff in the stock market and a general economic backdrop that could head south quickly. The wage earner in us, the consumer in us and the investor in us are all tremendously challenged with the price inflation backdrop. The investor in us is looking at a bond market backdrop that is 70 years historically negative simultaneously with a stock market that is historically highly valued. That is a recipe for all sorts of potential problems in both markets. In recent decades the Fed has “came to the rescue” of markets when they were in difficult backdrops via reducing interest rates and/or money printing via QE policies. They played that approach for too long and took it too far and now are in a bind and sadly, we the citizenry, with all of the various hats that we all wear, are right there with them. With this, be careful out there in market land. For our part, relative to the assets under our management, we continue to employ caution. I wish you well…
Director, Market Research & Portfolio Analysis
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