Bonds Are Getting More Interest
One of the most important questions for investors is whether interest rates will remain low. Persistent paltry yields still aren’t fully explained. Inflexible investment mandates affecting trillions of dollars are a partial explanation. For example, the equity risk premium favors stocks sufficiently that it’s possible to replace a ten-year government bond with as little as 20% of the money reallocated to stocks and 80% in cash (see Stocks Are Still A Better Bet Than Bonds).
The resulting barbell has a very high likelihood of delivering the same return or better than bonds, but conservative assumptions still fall short of a guaranteed outcome. Even though low yields should induce investors to allocate more to stocks, pension funds, central banks and others with rigid fixed income mandates continue to hold vast amounts of bonds with derisory yields.
Related to this is the continued drop in real yields. It’s a phenomenon that’s lasted several decades. The series below shows real yields on the average of U.S. government inflation-indexed bonds (TIPS) for over twenty years.
The decline in real yields led the FOMC to change how they implement monetary policy. A couple of weeks ago Federal Reserve Vice-Chairman Richard Clarida explained that the decline in real rates had also led FOMC members to steadily revise their forecast equilibrium policy rate lower. It’s fallen from 4.25% in 2012 to just 2.5% now. Even at that level, given the FOMC’s 2% inflation target it implies a neutral real policy rate of +0.5%, whereas long term TIPS yields are negative. That means that the FOMC may eventually revise their neutral policy rate lower still.
The reduced neutral short term rate is why the FOMC is willing to tolerate inflation modestly above 2%. Low rates offer less room to cut during a recession. The FOMC felt this risked inflation remaining below 2%, too close to damaging deflation for them to be comfortable.
Back in the 80s and 90s bond markets were interesting. Fed policy moved with economic cycles. Eurodollar futures could be traded. Since then, interest rates have offered many years of comparative boredom, with the 2008 financial crisis and Covid recession offering a brief respite from the slumber that enveloped fixed income.
We are likely entering a much more stimulating era. Bond markets are becoming interesting again and will command more attention from investors.
Excesses are building up. The government acknowledges few limits on spending (see Modern Monetary Theory Goes Mainstream). There are no fiscal hawks left in Washington. The Federal Reserve is partially monetizing the debt, by buying around $120BN per month. They have somehow convinced themselves that left unchecked bond yields would constrain economic activity, even though rates globally are low by any reasonable measure.
The FOMC is actively seeking higher inflation, insisting that when it appears it’ll be temporary and therefore insufficient to draw a policy response. They’ve also ruled out inflation in food and energy (always temporary and mean-reverting), housing (they always ignore this – see Why You Can’t Trust Reported Inflation Numbers), and many commodities (Covid-related logistical problems that will resolve themselves) as sources of concern.
Only rising wages will prompt them into action (see The Fed’s Narrowing Definition Of Inflation). The doctrine driving monetary policy is that it’s better to be late than early in tightening. Prior tightening cycles were often preceded by a concern that the Fed was late. Such fears may last longer than in the past, since this time tardiness is their intent.
Such circumstances create uncertainty about the outlook for interest rates, a key support under equity markets. They also make it more important for investors to consider inflation separately from interest rates, since the FOMC is relaxing the tether that historically connects them.
For much of the past five years nominal and real interest rates stayed close, reflecting stable inflation expectations. Covid and the resulting uber-stimulus have altered the relationship. Real interest rates have stayed negative – an implicit forecast of stealth monetization of debt.
In 2013 I published Bonds Are Not Forever: The Crisis Facing Fixed Income Investors. It forecast continued low interest rates and negative real yields as a relatively painless solution to excessive debt. Circumstances have continued in that direction, with Covid accelerating the trend. Currency debasement has a long history, as I recounted in the book. A client recently suggested I write an update.
The rise in ten-year treasury yields this year has prompted more investors to consider how they should respond to higher inflation expectations. The recent drop in nominal yields hasn’t been caused by moderating inflation fears – real yields have also dropped.
One could infer from this a growing realization by the market that the Fed won’t be quite as ready as in the past to protect purchasing power. Negative real yields should prompt greater urgency in the search for assets that will provide inflation protection. Investors need to look after themselves, since the Fed won’t.
We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.
The information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy, completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments. Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.
References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)
This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r
Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.
All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.
Past performance of the American Energy Independence Index is not indicative of future returns.
Spot on Simon….your book was excellent, as I recall writing at the time, and an updated edition would be timely and helpful for many investors. It I hard to avoid the conclusion that the Fed is locking itself into a policy framework from which no easy exit will in practice be possible. A subsidiary issue is what medium to longer term returns can be achieved when you start with negative real yields. The historical record is not encouraging for many asset classes. You have to worry about the viability of many/most pension funds in this environment. Best wishes Jonathan. (PS Now writing and podcasting for my own website and enjoying the freedom that it brings).