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If you own bond funds, you’ve no doubt suffered losses — maybe even big losses — over the past few months.
The Barclays U.S. Aggregate Bond Index has fallen 2.16 percent from the beginning of the year through last week. And a Barclays’ index that tracks 10- to 20-year U.S. Treasuries has sunk 6.35 percent. That’s as the yield on the benchmark 10-year Treasury has risen from 1.75 percent to just above 2.5 percent, with more increases on the way, economists and investors say.
But my advice is: Don’t abandon your bond funds just yet. That’s because the low in U.S. bond yields has yet to be recorded. I found supporting information compiled by Lacy Hunt, the chief economist at investment-management firm Hoisington Investment Management.
I realize that calling for lower yields in the quarters ahead puts me in the minority, as the wide-scale sell-off in the bond market attests. That’s why in today’s Money and Markets article, I’m going to provide you with two reasons why we’ll see lower rates for at least six months and probably 18 months. Next week I’ll reveal three more.
To start, it’s my view that the rise in long-term yields over the past several months was accelerated by the Federal Reserve’s announcement that it would soon be “tapering” its purchase of Treasury and mortgage-backed securities. That has convinced many bond-market investors that the low in long rates is in the past.
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| For interest rates to rise and stay there, faster inflation is, and has always been, the key factor. |
Inflation First
The Treasury market’s short-term fluctuations are the result of many factors, but the main and most fundamental determinant is the expectation for inflation. In other words, for interest rates to rise and stay there, faster inflation is, and has always been, the key factor.
Currently, there is no inflation in my forecast.
Inflation’s role in setting long-term rates was quantified by Irving Fisher 83 years ago (“The Theory of Interest,” 1930) with the Fisher equation, which says that long-term rates are the sum of inflation expectations and the real rate.
Since then, dozens of historical studies have reaffirmed that proposition. It can also be empirically observed by comparing the Treasury bond yield to the inflation rate, which have moved in the same direction about 80 percent of the time (on an annual basis) since 1954.
Presently, the level of inflation is most favorable to bond yields. The year-over-year change in the core personal consumption expenditures deflator, an indicator to which the Fed pays close attention, stands at a record low for the entire five-plus decades of the series.
Additional conditions restraining inflation are the appreciation of the dollar and the decline in commodity prices.
The dollar is up almost 15 percent from its 2011 lows. A higher dollar leads to reduced prices of imports, which have been deflating at a 1 percent rate (excluding energy) over the past year. When importers cut prices, domestic producers are forced to follow.
Along the same line, commodity prices have dropped more than 20 percent from their peak in 2011, tempering inflation.
Sluggish Economy
The second reason I don’t think the recent increase in interest rates is permanent is that GDP growth, whether if measured in nominal or real terms, is the slowest of any expansion since 1948.
Nominal gross domestic product grew 3.3 percent from the first quarter of 2012 through the first quarter of 2013.
Real GDP shows a similar pattern. For the past four quarters, real economic growth was just 1.6 percent, even less than the 1.8 percent growth rate in the 2000s and dramatically less than the 3.8 percent average in the past 223 years. Those results demonstrate chronic long-term economic underperformance.
Over the past year, the Treasury bond yield rose as growth in nominal GDP slowed. The difference between those two indicators is important in two respects. First, when the bond yield rises more rapidly than the GDP growth rate, monetary conditions are a restraint on economic growth.
This condition occurred prior to all the recessions since the 1950s, as indicated in the chart. Second, the nominal GDP growth rate represents the yield on the total economy, a return that embodies greater risk than a 30-year Treasury bond. Thus, the differential is a barometer of opportunity for bond investors.
On two occasions in the 1990s, the Treasury bond/GDP differential both rose sharply. But in each instance, no recession ensued. Instead, bonds turned in a stellar performance over the next year or longer. This economic indicator further supports my position that bonds are well-positioned to rally from current levels.
That’s why I’m recommending that if you’re a bond-market investor, stay calm for a bit longer and see if interest rates begin to back off, as I suspect. For a suggestion on an investment that can weather higher rates — and even gain from them — please see Money and Markets’ Facebook page by clicking this link.
Remember, next week I’ll provide you with three more reasons why you may see interest rates ease, allowing your bond funds to recover some of the value they’ve lost. In addition, I’ll reveal a little-known fact about the volatility of interest rates over the past 45 years that you really need to know.
Best wishes,
Bill
Bill Hall is the editor of the Safe Money Report. He is a Certified Public Accountant (CPA), Chartered Financial Analyst (CFA) and Certified Financial Planner (CFP). Besides his editorial duties with Weiss Research, Bill is the managing director of Plimsoll Mark Capital, a firm that provides financial, tax and investment advice to wealthy families all over the world.
{ 8 comments }
How on earth can you claim there's not inflation unless you're buing the party line fed to the mindless masses by the Fed?
Since you are using govt numbers, for inflation, and not the real inflation rate, both your inflation and GDP numbers are incorrect.Time to realize that politicians lie, to get elected and lie after elected.They do it, to protect themselves and because, they don't think the masses can handle the truth.
As the article says, look at the core personal consumption expenditures deflator — it stands at a record low.
Also, a rising U.S. dollar is deflationary, not inflationary.
Yes, there are certain geographies in the U.S. – New York City and Boston – where real estate prices and rents have had an inflationary impact. In North and South Dakota, there is inflation because of the fracking boom.
But, overall, we are in a weak economic environment without a lot of inflation in the system. In fact, deflation is a greater risk right now, especially if the government withdrawals stimulus. –Bill Hall
Mike Larson and Martin Weiss just posted that the bonds are being dumped. That things are falling apart and yet you are saying that bonds will increase driving the interest rate down? I am confused on your stances.
I think it is worth mentioning that the world is sitting on ALOT of US dollars and right now. China and the BRICS are in talks about trading commodities without using the USD. Once the US defaults (or admits that it has too much debt) where do you think all that "Exported Inflation" is going to end up? Right back in the Americans hands. You cannot print a trillion dollars a year and not expect it to snap back. I do not believe deflation will be an issue for you guys.
Are you sure the rising USD isn't due to other countries currency devaluation? Or perhaps the expected turn in commodity prices?
I pray to god I am wrong, but Economics law states that you simply cannot print money and not get inflation.
Economics is not a physical science like chemistry or physics. Which says, if this happens then that has to happen.
Economics is an “applied science†based on past experiences and observations.
Yes, generally speaking, when you print money you will get inflation. And I think, it’s going to happen sometime in the future. Just not now. We have been printing money for almost 5 years and where is the inflation? We are still battling deflation. That’s because the money multiplier and velocity have collapsed. So the Fed can print away but there is no inflation until the multiplier and the velocity increase or at least stabilize. That’s because without a multiplier or velocity the money can’t get into the system.
The other possible outcome from money printing is massive deflation caused by a liquidity trap where you get massive devaluation like occurred in Germany and the US early in the 20th century. So printing money doesn’t necessarily mean inflation.
I think we have another 18 months to 2 years of no inflation and slow to no economic growth, then inflation kicks in. We’ve been waiting for 5 years for inflation and still none so if you’ve been waiting you’ve missed out on making A LOT of money. It’s a matter of sequencing – slow growth, fight deflation, then inflation.
And yes, waiting is acceptable too depending on personal circumstances. But remember, a broken clock is right twice a day. –Bill
Thank you Bill for your perspective. I tend to follow the Austrian's in a world of Keynesians and Monetarists. That said, I've long held that we would see deflation, your work shows this well, followed by devastating price inflation due to what is real inflation (i.e. Expansion of the money supply via Fed easing). Their manipulation results in uneven money flow (e.g. Currently to the stock market) bubbles and busts while, as you point out, the real economy goes without needed credit.
On a Macro level one can see your point. However, on a Micro level, at the grocery store, packaging is smaller thus less value/dollar is going to the consumer. Deflating items like computers and cars seemed to have bottomed. Housing is up. The dollar has devalued ever since the Fed was created in 1913.
I once had the opportunity to ask a question of famed market technician, John Murphy. I asked if there was a time when all asset classes declined? He thought for a moment and replied, "Yes, during the Great Depression". My question to you, What is one to do in what I would term the Great Oppression?
Thanks for your question, Terry. During the “Great Oppression,†as you say, Americans should own what central banks can’t print: land, gold and private business interests in closely held companies.
In terms of financial assets, I would sit on loads of dollars because the U.S. is still the world’s largest free economy. When the global financial markets collapse again — and they will because of the unresolved debt overhang in the developed world — I would “back up the truck†and buy large multinational blue-chips and high-quality emerging-market companies that focus on domestic consumption. I’m taking the long view, something few investors are willing to do. –Bill
Thank's Bill. Good advice. I'm on the same page with you.