Key Points: – 10-year Treasury yield rises to 4.41% amid geopolitical and inflation concerns. – Putin lowers nuclear strike threshold; U.S. embassy closures signal heightened tensions. – Federal Reserve official warns of stalled inflation progress despite near-full employment.
U.S. Treasury yields rose on Wednesday as investors grappled with the dual challenges of escalating geopolitical tensions and evolving domestic economic conditions. The yield on the 10-year Treasury climbed 3 basis points to 4.41%, while the 2-year yield increased by the same amount to 4.302%. These moves reflect heightened investor caution as uncertainties cloud both global and U.S. economic outlooks.
At the forefront of global concerns is the ongoing Russia-Ukraine conflict. The United States closed its embassy in Kyiv on Wednesday, citing the risk of a significant air attack, signaling heightened tensions in the region. Compounding the situation, Russian President Vladimir Putin announced changes to Russia’s nuclear doctrine, reducing the threshold for a nuclear strike. This alarming shift follows Ukraine’s use of U.S.-made long-range ballistic missiles to target Russian territory, introducing a new layer of unpredictability to the geopolitical landscape. Such developments have rippled through financial markets, prompting investors to weigh their exposure to riskier assets and seek refuge in safer options like Treasuries, despite rising yields.
Domestically, Federal Reserve Governor Michelle Bowman provided a sobering perspective on inflation. Speaking in West Palm Beach, Florida, Bowman stated that progress toward the Fed’s 2% inflation target has stalled, even as the labor market remains robust. She highlighted the delicate balance the Fed must strike between achieving price stability and maintaining full employment, cautioning that labor market conditions could deteriorate in the near term. This acknowledgment has fueled speculation that the Fed may maintain its higher-for-longer interest rate stance, adding further pressure to bond yields.
Economic data due later this week could shed light on these dynamics. October’s flash purchasing managers’ index (PMI) reports from S&P Global are anticipated to provide critical insights into the health of the manufacturing and services sectors. A decline in PMI figures could reinforce concerns about an economic slowdown, while stronger-than-expected data might reignite inflation fears. Investors are also paying close attention to remarks from Federal Reserve officials later in the week, which could offer clues about the central bank’s next moves.
Adding to the uncertainty, the transition to a new Treasury Secretary under President-elect Donald Trump has become a focal point for market participants. Speculation about potential candidates has raised concerns about their experience and ability to navigate complex fiscal challenges. With geopolitical risks, inflation pressures, and evolving monetary policy already in play, the choice of Treasury Secretary will likely influence investor confidence and fiscal strategy in the months ahead.
As these factors converge, the bond market remains a key barometer of investor sentiment. Rising yields reflect a balancing act between risk and return as markets digest the interplay of global turmoil, domestic policy signals, and economic data. Investors will continue to watch these developments closely, with each data release or policy announcement potentially reshaping market dynamics.
Key Points: – U.S. Treasury yields declined as investors shifted to safer assets amid election and Fed uncertainty. – Polls show Kamala Harris and Donald Trump in a dead heat, raising concerns about congressional control and potential policy impacts. – A quarter-point rate cut is widely expected from the Federal Reserve this week, aimed at stimulating economic growth.
US Treasury yields fell on Monday as investors braced for a high-stakes week, with the upcoming U.S. presidential election and a key Federal Reserve rate decision poised to influence the economy and markets. The 10-year Treasury yield dropped nine basis points to 4.27%, while the 2-year yield decreased by over six basis points to 4.14%. These declines come as investors shift focus to safer assets amid election uncertainty and expected economic shifts. Yields, which move inversely to bond prices, reflected some caution as traders weigh potential election outcomes and their economic implications.
Polls indicate a tight race between Vice President Kamala Harris and former President Donald Trump, with NBC News showing the candidates locked at 49% each. Investors are particularly attentive to which party will control Congress, as this could dictate future policy moves, ranging from government spending to tax reforms. A split Congress would likely mean legislative gridlock, whereas a unified government might lead to significant policy changes. The election results could potentially impact stock markets, which experienced a volatile Monday, with the Dow Jones Industrial Average falling by 225 points or 0.5%, and both the S&P 500 and Nasdaq dipping by 0.2%.
In addition to the election, the Federal Reserve’s policy meeting on Thursday could mark another pivotal moment for markets. Analysts widely anticipate a quarter-point rate cut following the Fed’s recent 50 basis point cut in September. Traders are pricing in a 99% probability of this move, as tracked by CME Group’s FedWatch Tool. A rate cut could reduce borrowing costs and stimulate economic growth, potentially offsetting some of the anticipated volatility tied to the election.
Also weighing on markets were economic data points, with September factory orders down 0.5% in line with expectations. The Purchasing Managers Index (PMI) is due on Tuesday, and these indicators may provide additional insight into the economy’s current health as markets prepare for Fed Chair Jerome Powell’s comments on Thursday. Analysts suggest Powell’s statements could hint at the Fed’s future outlook for rates, as the central bank navigates a gradually slowing economy.
The shift towards Treasurys reflects a defensive stance by investors seeking stability amid looming uncertainties. Michael Zezas, a strategist at Morgan Stanley, suggested patience will be crucial for investors as they navigate potential market noise surrounding the election. The Treasury market’s reaction indicates some investors are bracing for turbulence in stocks if the election results lead to unexpected outcomes. The safe-haven nature of U.S. bonds offers a buffer for investors looking to mitigate risk in a potentially volatile environment.
Adding to market dynamics, Nvidia shares climbed 2% on Monday after it was announced the company would replace Intel in the Dow Jones Industrial Average, a change reflecting Nvidia’s year-to-date rise of 178% as it capitalizes on the AI sector. This development underscores a broader trend where technology and AI stocks remain central to market sentiment.
As election day approaches, financial markets are set to respond not only to the presidential outcome but also to shifts in Congress. With the Fed’s decision and further economic indicators expected this week, both equities and bond markets may experience heightened volatility, particularly if post-election policy signals lead to significant shifts in fiscal or monetary policy.
Key Points: – The 10-year Treasury yield fell below 4% for the first time since February, responding to Fed Chair Powell’s comments on potential rate cuts. – Economic indicators, including increased jobless claims and a contraction in manufacturing activity, suggest a cooling economy. – The Federal Reserve is closely monitoring economic data to determine the timing of potential interest rate reductions.
In a significant shift in the financial landscape, U.S. Treasury yields have taken a noticeable downturn, with the benchmark 10-year yield dipping below the 4% mark for the first time since February. This movement comes in the wake of Federal Reserve Chairman Jerome Powell’s recent comments, which have opened the door to potential interest rate cuts as early as September.
The yield on the 10-year Treasury, a key indicator of economic sentiment and borrowing costs, fell to 3.997% on Thursday, August 1, 2024. Simultaneously, the 2-year Treasury yield, which is more sensitive to short-term rate expectations, slipped to 4.23%. These declining yields reflect growing investor confidence that the Fed’s tightening cycle may be nearing its end.
Powell’s remarks following the July Federal Open Market Committee (FOMC) meeting have been pivotal in shaping market expectations. The Fed Chair indicated that the economy is approaching a point where reducing the policy rate might be appropriate. This statement has been interpreted as a signal that the central bank is preparing to pivot from its aggressive rate-hiking stance to a more accommodative policy.
However, Powell emphasized that any decision to cut rates would be data-dependent, considering factors such as economic indicators, inflation trends, and labor market conditions. This cautious approach underscores the delicate balance the Fed must maintain between curbing inflation and supporting economic growth.
Recent economic data has added weight to the case for potential rate cuts. The latest report on initial jobless claims showed a surge to 249,000 for the week ended July 27, significantly exceeding economists’ expectations. This increase in unemployment claims, coupled with rising continuing claims, suggests a potential softening in the labor market – a key area of focus for the Fed.
Furthermore, the Institute for Supply Management’s (ISM) manufacturing index came in at 46.8, falling short of forecasts and indicating a contraction in manufacturing activity. A reading below 50 on this index signifies economic contraction in the sector, adding to concerns about overall economic health.
These economic indicators paint a picture of a cooling economy, which could prompt the Fed to consider easing its monetary policy sooner rather than later. Some market analysts, like Adam Crisafulli of Vital Knowledge, argue that these signs of economic slowdown suggest the Fed should have already begun its easing cycle.
As investors digest these developments, the bond market has responded with lower yields across various maturities. The yield curve, which plots yields across different bond maturities, has shifted downward, reflecting expectations of lower interest rates in the future.
Looking ahead, market participants will be closely watching upcoming economic data and Fed communications for further clues about the timing and extent of potential rate cuts. With three more Fed meetings scheduled for this year, there’s ample opportunity for the central bank to adjust its policy stance if economic conditions warrant such action.
The decline in Treasury yields has broader implications for the economy. Lower yields can lead to reduced borrowing costs for businesses and consumers, potentially stimulating economic activity. However, they also reflect concerns about economic growth and can impact returns for fixed-income investors.
As the financial world grapples with these evolving dynamics, the interplay between economic data, Fed policy, and market reactions will continue to shape the trajectory of Treasury yields and the broader economic outlook in the months ahead.
The recent sharp sell-off in the bond market has sent shockwaves through financial markets, impacting investors and consumers alike. This sell-off is characterized by rising yields on U.S. government bonds, particularly the 10-year Treasury note. As we delve into the implications of this development, it’s crucial to consider the historical context and the ripple effects on stock markets, investors, and consumers.
Rising Yields and Interest Rates:
Yields on government bonds, especially the 10-year Treasury note, play a pivotal role in shaping interest rates across the financial spectrum. Mortgage rates, credit card rates, and other forms of debt are closely tied to these yields. The yield on the 10-year Treasury note, widely viewed as one of the safest investments globally, recently surged above 5%, a level not seen since 2007.
Drivers of the Sell-Off:
Several factors have fueled this bond market sell-off. Stronger-than-expected economic data has boosted the outlook for the U.S. economy. The government’s deteriorating financial condition, coupled with concerns over mounting debt levels, have also contributed to the sell-off. In 2022, the bond market faced its worst year on record, with the Federal Reserve aggressively raising interest rates to combat high inflation.
Inverse Relationship: Bond Prices and Yields:
The inverse relationship between bond prices and yields is a cornerstone of the bond market. When yields rise, bond prices fall. This dynamic has been particularly pronounced in recent weeks, pushing yields higher.
The Fed’s Role and Economic Implications:
The Federal Reserve, the U.S. central bank, has played a pivotal role in the bond market. During the pandemic, it acquired trillions of dollars’ worth of fixed-income securities to support the economy. However, since 2021, the Fed has been gradually reducing the size of its portfolio. Over the past 18 months, the Fed has hiked benchmark interest rates by over 500 basis points.
Fed Chair Jerome Powell recently indicated that the central bank will approach its monetary-tightening measures carefully. The Fed’s priority is to tame inflation, which may require maintaining higher interest rates for an extended period, further influencing the bond market.
Growing Debt and Downgrades:
Wall Street’s concerns are further compounded by the United States’ escalating debt levels. Fitch Ratings recently downgraded the country’s bond rating from AAA to AA+. The U.S. budget deficit has surged in the latest fiscal year, with the outstanding debt reaching a staggering $33.64 trillion. Notably, the debt has increased by $640 billion in just the past five weeks.
Impact on Stock Markets and Investors:
The bond market’s turbulence can have a pronounced impact on stock markets. The rise in bond yields can make fixed-income investments more attractive, potentially diverting capital from stocks. This shift in investor sentiment has been a factor in the recent decline in U.S. stock markets in the latter half of 2023.
Consumer Implications:
Consumers are not immune to the repercussions of a bond market sell-off. Rising yields tend to result in higher borrowing costs, impacting mortgage rates, credit card rates, and other forms of consumer debt. Consumers may also experience the indirect effects of a less accommodative monetary policy, which can influence overall economic conditions.
In summary, the bond market’s recent sell-off, with surging yields and growing debt concerns, has multifaceted implications. It underscores the intricate interplay between bond markets, stock markets, investors, and consumers. As the Federal Reserve continues to navigate the path of monetary tightening, the financial landscape remains fluid, and stakeholders must adapt to these evolving dynamics.
The bond market is sounding alarm bells about the economic outlook. The yield on the 2-year Treasury briefly exceeded the 10-year yield this week for the first time since 2019. Known as a yield curve inversion, this phenomenon historically signals a recession could be on the horizon.
While not a guarantee, yield curve inversions have preceded every recession over the past 50 years. Here is what is happening in the bond market and what it could mean for investors.
Why Did Yields Invert?
Yields on short-term bonds like 2-year Treasuries tend to track the Federal Reserve’s policy rate. With the Fed aggressively hiking rates to combat inflation, short-term yields have been rising quickly.
Meanwhile, long-term yields like the 10-year are influenced by investors’ growth and inflation expectations. As optimism over the economy’s trajectory wanes, investors have been driving down long-term yields.
This dynamic inversion, where short-term rates exceed longer-duration ones, reflects mounting concerns that the Fed’s rate hikes will severely slow economic activity. Markets increasingly fear rates may cause a hard landing into recession.
The yield curve has flashed the most negative signal since the lead up to the pandemic recession. This suggests investors see a lack of catalysts for growth on the horizon even as inflation remains stubbornly high.
Ongoing supply chain problems, the war in Ukraine putting pressure on food and energy prices, and fears of a housing market slowdown are all weighing on outlooks. There is a sense the Fed lacks effective tools to bring down inflation without crushing the economy.
Meanwhile, key economic indicators like manufacturing surveys have weakened significantly. This points to activity already slowing ahead of when rate hikes would take full effect.
Implications for Investors
The risks of a recession are rising. Yield curve inversions have foreshadowed every recession since the 1950s. However, they have also sometimes occurred 1-2 years before downturns start.
This suggests investors should prepare for choppiness, but not panic. Rotating toward more defensive stocks like healthcare and consumer staples can help portfolios better weather volatility. At the same time, cyclical sectors like tech and industrials could face more pressure.
In fixed income, short-term bonds may offer opportunities as the Fed potentially cuts rates during a downturn. But credit-sensitive sectors like high-yield bonds and leveraged loans could struggle if defaults rise.
While uncertainty abounds, the inverted yield curve highlights the delicate balancing act ahead for the Fed and concerns over still-high inflation. Investors will be closely watching upcoming data for signs of how quickly the economy is slowing. For now, caution and safe-haven assets look to be in favor as recession worries cast a long shadow.
Doomsday Investor Sees Ongoing Moves by Policymakers as Destructive
We’d all like to think that global decision-makers responsible for economic conditions have the best interest of the world’s citizenry in mind when making decisions – but doubts and concerns are growing. Among the most concerned are economic stakeholders that don’t believe “bad” things should always be prevented. One very credible voice highlighting this idea is hedge fund manager Paul Singer. He’s the CEO of Elliot Investment Management and recently moved his firm’s offices out of NY, NY, to the more business-friendly West Palm Beach, FL. Singer says a credit collapse and deep recession may be needed to restore financial markets.
Paul Singer is the founder and CEO of Elliott Investment Management. Its year-end 13F reportable AUM was $12.25 billion. The firms opportunity-based investment style allows Singer and Company, known for their corporate activism, to move to wherever profit may lie.
The current thinking of Singer, a registered Republican, has been making headlines. This includes a widely circulated opinion piece published in the Wall Street Journal last week. In it, he discusses more than a decade of what he believes are damaging easy-money policies and how a deep recession and even credit collapse will be necessary to purge financial markets of excesses.
“I think that this is an extraordinarily dangerous and confusing period,” Singer told The Journal, in his interview, he warns that trouble in markets may only be getting started now that a full year has passed from the start of tighter monetary policy.
One of the more chilling quotes from Singer is, “Credit collapse, although terrible, is not as terrible as hyperinflation in terms of destruction wrought upon societies.”
The idea that we are headed down either one path or the other, he doesn’t mention a third option, may be why the New Yorker magazine calls him “Doomsday Investor.” He explains, “Capitalism, which is economic freedom, can survive a credit crisis. We don’t think it can survive hyperinflation.”
The Doomsday Investor has been outspoken against government safety nets for a while, including the sweeping banking regulations from the Dodd-Frank Act of 2010. This act created the Financial Protection Bureau (CFPB) and established the Financial Stability Oversight Council (FSOC). Singer strongly opposed prolonged market interventions by global central banks following the 2008 global financial crisis. Interventions that still haven’t been drained from the U.S. monetary system.
Singer, who is 78 called crypto, “completely lacking in any value,” in his WSJ interview. He also said: “There are thousands of cryptocurrencies. That’s why they’re worth zero. Anybody can make one. All they are is nothing with a marketing pitch—literally nothing.”
While his funds performance have placed him near the top of hedge fund manager performance, Singer personally worries the Fed and other central banks will respond to the next downturn by referring to the failed playbook of slashing interest rates and potentially resuming large-scale asset purchases. The point was shown to be current, as Singer called the regulatory response to the collapse of Silicon Valley Bank and Signature Bank, including the guaranteeing of all deposits from the two lenders akin to “wrapping all market movements in security blankets.”
He complained, “…all concepts of risk management are based around the possibilities of loss.” He encouraged decision makers to, “Take it away, it’s going to have consequences.”
Where Can Investors Hide
Paul Singer said in his interview there may be a few places for investors to ride out what he sees as a coming storm. One place comes as no surprise, “At such times, some consider the safest bet to be relatively short-term U.S. government debt,” he said, adding that “such debt pays a decent return with virtually no chance of a negative outcome.” He is likely speaking of U.S. Treasuries two years and shorter as the longer duration bonds would be more volatile as rates shift, and other government debt like GNMAs are fraught with extension risk.
Singer also believes some gold in portfolios may make sense.
Take Away
Without some rain, nothing could flourish. Without an occasional brush fire, the risk of massive forest fire greatly increases. Paul Singer, in his interview with the WSJ, indicates he believes the economic brushfires that decision-makers have been preventing should have been allowed to run their course. Preventing them is a big mistake and a collapse may not be far off.
This collapse in easy credit and crypto, among other bubble-type excesses Singer believes could be destructive but preferred by society over continuing to move toward hyperinflation.
Owning a Balanced Diversified Investment Portfolio Has Been Like Watching a Train Wreck
From the time that most realized the Fed would aggressively deal with inflation, watching the classic 60/40 balanced portfolio has been like watching a slow train wreck.
Diversification, balance, a 60/40 allocation have been the marching orders from those “in the know.” But what do you do when you’re terribly sure that the 40% in bonds will be worth less tomorrow, and the 60% in a standard stock index is more likely to be down than up? This is the question investors, wealth managers, and retirees have been faced with since early in 2022. The Chair of the Federal Reserve promised to raise rates, so the 40% allocation in bonds has been almost guaranteed by a Federal agency to perform worse than cash in your pillow case, and when interest rates rise, the economy does worse, which at first weighs down stock indexes.
Advisors want their customers to sleep better at night, so they tell them not to worry, no one can call the market, you don’t want to miss the up days. Every time, the markets have bailed them out, and there is no reason not to think that there won’t continue to be eventual increases on one side or the other of the investment pie chart. Meanwhile, missing predictable down periods are just as important to exceptional long-term results as being invested when values rise.
60/40 101
The classic portfolio of 60% stocks and 40% bonds touted in articles by wealth managers and certified by textbooks on investing may no longer provide the same level of returns that it delivered previously. Or it may be going through a period where the direction of stocks and bonds is highly correlated – and it will at some point turn the corner to balanced performance.
From the 1980s until recently, a portfolio of 60% stocks and 40% bonds did well for investors and for good reason. The mix consistently provided investors with attractive risk-adjusted returns, with total returns often equal to or better than those of the S&P 500 Index and with lower volatility. In a more natural market, rates come down (bond bull market) when the economy is weak, which brings stock prices down (stock bear market) and visa versa. The investor always has positions in a bull market to partially offset losses from the other side of the portfolio.
Recent History of Balanced Portfolios
But this strategy hasn’t really worked for decades. Many haven’t noticed because its not working has benefitted investors. Debt and equity prices have moved in the same direction. Both stocks and bonds have reached new highs through last year. Investors aren’t critical when they’re making money, but both markets joined hands long ago and have been mostly moving in the same direction. Here’s your evidence; in 1982, a 30 year-treasury bond was issued, paying over 14%. Today the 30-year is paying 3.65%. So the bond market, with slight ups and downs, has been strong for most of the last 40 years. The S&P 500 in 1982 closed at 120. Today, the same index is at 3,675. Both markets, although not always trading hand in hand, more often than not rise and fall together.
Image: 60:40 Blackrock portfolio performance since 2011 (Koyfin
60/40 in 2022
The protection of hiding behind a broad, diversified index of stocks and conservative (supposedly uncorrelated) bonds is certainly showing its weakness this year. Persistent structural inflation adding to interest rates and negative GDP growth have battered both markets. It exposes that 60/40 is not perfect and that set-it and forget-it could cause many to have large drawdowns that will require huge percentage increases in the future.
What to Do
When the most powerful mover of assets transparently says they are going to do something that will impact the markets, believe that the odds are that they will. In other words, don’t fight the Fed. This could mean a slight to a total reduction in bonds, why watch your bond portfolio become a train wreck. And if you are in bond funds, a move to individual bonds offers the solace of at least knowing they mature at par.
The stock portfolio is trickier. The equities market will turn around when there are signs that the economy has bottomed out. Currently, there are some signs of weakness, but mostly expectations of great weakness as we know the Fed is resolved to tame inflation. Investors will race to be first in on the most recent dip. Selectively picking stocks that have a good reason to outperform now and be strong later when bullishness returns is likely smarter than holding a broad-based index. The broad-based economy is headed lower, so it stands to reason the broad-based indexes have further to fall.
Don’t be a stranger to analysts’ reports on individual companies. Expert, unbiased analysis of sectors and individual stocks can help you uncover those that are unlinked to negative world events or are taking advantage of global changes.
Cash was trash when rates were near zero. Currently, a three-month T-Bill yields around 3.75%. Other short and safe securities are closer to 4%. When there is a recognizable turnaround, you’ll want ammunition. Keep some dry powder to be able to pounce; today’s short interest rates provide returns above those expected in the major indexes. Check with your broker to find out how to invest in short-term agencies, T-Bills, or broker CDs so you are ready for when the Fed says they are in a wait-and-see mode, for when GDP shows we are clearly not in a recession, for when corporate earnings are on the rise, and for when interest rates on bonds are closer to a level that produces low inflation numbers.
Take Away
Stocks and bonds have mostly been moving in the same direction for a very long time. Both were moving up, so no one noticed.
Cash is also an option in any portfolio, and you’re now getting paid more. If the Fed continues to suggest rates are rising, it practically ensures lower bond prices. Move to cash or carefully selected equities. Look for quality analysis of sectors and stocks before jumping into a stock. News stories, statistics, and often research and analysis on small-cap opportunities are available for those signed-up for Channelchek emails, along with many other no-cost perks.
What’s the Best Inflation Fighter for Your Savings? Stocks or TIPS?
At a minimum, an investor with an eye toward having more, not less, in the future needs to beat the rate of inflation. Ideally, since the investor ties up their money, the buying power in their account should provide the current inflation rate plus a risk premium over the medium to long term. During the past few months, a number of long-term savers/investors have asked me what I thought about TIPS as a means of exceeding inflation. I have strong opinions on these Treasury securities. My thoughts are rooted in having been a portfolio manager for the country’s second-largest fixed income fund manager back in 1996 when the U.S. Treasury asked for our input on the design of the new bond. The Treasury wanted us to approve of the bonds enough to invest in them – in early 1997 I pulled the trigger on $100 million in the first ever TIPS auction – that was 25 years ago, and there is now enough data to compare the performance of Stocks, TIPS and the rate of inflation. Which one provides better inflation “protection”?
Some Details on TIPS
If you aren’t aware of the intricacies and history of the Treasury Inflation-Indexed Securities, dubbed TIPS, as the working name for the project back in 1996, here’s what you should know in a two paragraphs.
Interest rates were declining through the late 1990s and the Treasury Secretary Robert Rubin had a plan to lessen the government’s interest rate burden by issuing a bond with costs that would be lower with the declining inflation and interest rates. The Canadians, British, and Australians all had a bond type that floated with the countries’ inflation index. The Canadian-style bond had a fixed rate of interest where the principal accreted upward with an inflation index. On this new principal, an unaffected fixed-rate (coupon) would pay interest. The British and the Aussies paid the inflation addition with the coupon, the bondholder didn’t have to wait until maturity to be compensated for price increases. The U.S. adopted the Canadian system of accreting to principal.
The new bond was to be helpful to the U.S. Treasury, the conservative investor, and even the Federal Reserve. Inflation was sinking at the time, so investors were attracted in part to the idea that the securities effectively have a floor since the Treasury would never lower the principal accretion to below zero even if deflation became a problem. Retirees were told they should be thrilled to have a low-risk investment to choose from that paid inflation plus. The U.S. Treasury was looking forward to being able to reduce the interest costs of its debt as there were still bonds outstanding that were paying 14%. As for the Chairman of the Federal Reserve, Alan Greenspan, he was thrilled he’d have a constantly updating investor-driven mechanism that would indicate the market’s current expectation of inflation.
Inflation “Get Real”
Through the late seventies and into the early eighties, inflation was a big influencer on all household decisions. Durable items like washing machines were purchased sooner rather than later because they may cost much more later. Even borrowing to buy made good financial sense. As for investing or saving, buying short bonds or CDs that always paid more than inflations and then reinvesting similarly when it came due provided the investor with a little more income than inflation (and sometimes a free toaster). The stock market had years where it had negative returns, but for the medium or long-term saver, it far exceeded inflation. This has not seemed to have changed.
“Get Real” is a slogan that had been used by brokers trying to build enthusiasm for TIPS when they first came out. It refers to real yield, or put another way, the yield after inflation. TIPS were designed to pay the inflation rate plus an interest rate, so the investor earns a real yield. What no one anticipated when the securities were designed is the real yield could go negative, thus providing the investor with inflation minus whatever supply and demand decided.
The chart below demonstrates that over a recent 11-year period, TIPS paid negative real rates about a third of the time. They did not provide the investors with a return above the rate of inflation as originally envisioned.
Source: St. Louis Federal Reserve
Stocks are not designed to be correlated with the rate of inflation, but they generally do well when the economy is flourishing or expected to flourish (these periods tend to be associated with inflation). And equities fall off when there is a contraction or expectations of a bad business climate. The chart below uses the Russell 2000 Small-Cap Index as a measure of stock market performance. The period shown demonstrates that if one is looking to keep up with or beat inflation by any margin, Small-Cap stocks can be viewed as far superior to TIPS.
During the period from August 2012 until August 2022, prices have risen a combined amount of 28.558%, according to a calculator provided by the Bureau of Labor Statistics. During the same period, an investment in TIPS provided 13.11% to the saver/investor. This equates to a real return of negative 15% over ten years. If the purpose of the investor is to keep up with and beat inflation, TIPS have failed as a decent option.
As for stocks, the downside over short periods has been much larger and deeper declines than TIPS. However, after year one, the declines were never large enough to show underperformance. TIPS failed its main goal of inflation plus. If an investor instead put money in small-cap stocks, they would have exceeded inflation by 110%.
While this is not predictive of the future, it is compelling evidence for anyone with a time horizon beyond a few years to look at the true risk profile of each. TIPS have performed worse than inflation. One reason for this is that bond prices have been held lower than the market would naturally have them because the Fed has taken so many on its balance sheet.
Take Away
The performance of the stock market over the medium to long term has a long history of beating returns of other assets, especially those of bonds. Treasury Inflation-Indexed Securities, the official name for the bond, does not have a “P” in it. The “P” was supposed to stand for “Protected.” Just prior to the first auction, the name was changed as government lawyers pointed out these may not protect the investor from inflation.
The Federal Reserve owns a third of the outstanding U.S. Treasuries, including a large allocation of TIPS. This unnatural demand holds prices artificially below where the market would price them without the Fed’s impact. This skewing of the results would have been upsetting to former Fed head Alan Greenspan who felt the main appeal to the security was their ability to help predict future inflation.
Stocks have risks, and bonds have risks, if it’s inflation you’re looking to overcome, inflation-linked bonds have been historically off the mark.
