Do not look now but the flight to US Treasuries trade, which we had become conditioned to expect during market selloffs, no longer appears to be working, and interest rates no longer are trending lower. Investors have come to expect that bonds particularly US Treasuries would act as a shock absorber during volatile equity markets. More specifically when stocks go down, many have come to expect their bond portfolio will not only dampen volatility, but it will increase in value. With recent stock market declines and the market remaining down for the year, the S&P 500 officially registered a correction January 27th.
Investors may not have observed that it’s not only stocks that are down, but bonds are also down. Not only are bond indexes down year-to-date but they are down over the trailing twelve months too. Wall Street sold investors on the belief that this is not supposed to be so. Wall Street marketers sold investors bonds claiming when stocks decline, bond yields decline too. The result would be higher bond prices resulting in greater diversification benefits. The problem with that is the foundation for the claim was never all that strong to begin with. Wall Street makes money from taking trends and marketing them as long held truths.
Beginning back when the tech bubble burst over 20 years ago, stock prices and bond yields went from being negatively correlated to positively correlated. What does this mean for investors? Throughout much of financial history, stock and bond prices declined and rose together. Recall a basic rule of bond returns, when yields rise, bond prices decline and when yields decline, bond prices rise. 20 years is a long time and unfortunately many, if not most investors have come to accept the idea that bond prices rise when stock prices fall which is the goal of diversification benefits, uncorrelated asset returns. Analyzing well over a century of bond returns, the anomaly is likely not the last 12 months but the last 20 years, fueled by the trend in lower interest rates.
As you are painfully aware, inflation is running high. The Bureau of Labor and Statistics reported a 7.9% increase in the CPI (consumer price index) for the prior 12 months ending February. We last experienced inflation at these levels 40 years ago. At that time few economists if any in 1982, called a top for interest rates and inflation. However, one critical difference between then and now, interest rates were historically high then, and now are historically low. The Federal Reserve chairman back in 1982 was Paul Volcker and he deserves a great deal of credit in our humble opinion for breaking persistent inflation. Demonstrating perseverance, he kept the Fed funds rate at painfully high levels to tame inflation.
Americans had grown accustomed to experiencing high levels of inflation after it spiked higher in 1973, when the Arab oil embargo sent gas prices soaring higher. Gerald Ford would vow to whip inflation now (WIN) after becoming President in 1974. He did not win and Jimmy Carter’s subsequent administration would struggle with stagflation, low economic growth, and high inflation. In 1982 Federal Reserve Chairman Paul Volcker would maintain the Fed Funds rate at an average of 12.24%. Today, it’s level is 0.09%.
Interest rates are low, and inflation is high. Higher interest rates will prove necessary to combat inflation. The Federal Reserve chairman Jerome Powell has already conceded as much. Inflation has been higher than the Fed’s preferred target for a year now and it’s becoming increasingly difficult to seriously claim that inflation is in fact transitory. Consider the returns of three widely followed bond indexes in the table below. The returns both year-to-date and over the trailing twelve months are negative. Resulting higher interest rates and the further expectation of yet higher rates to come, could lead to continued, disappointing returns from fixed income. It’s likely we are in the early stages of a higher interest rate cycle.
Bloomberg US Aggregate Bond
Bloomberg US Government
ICE BAML US Treasury 1-3 Year
Curran Portfolio for Income Rep Account Net
Source: Orion Advisor Tech
Few fixed income managers today have any professional experience working in an inflationary environment with rising interest rates. Earning investors’, a positive return in a long-term declining interest rate environment is not especially challenging in comparison to a rising interest rate environment. Because interest rate cycles run much longer than both the stock and economic cycles, I would urge all fixed-income investors to evaluate their bond portfolios, set modest total return expectations and consider the merits of capital preservation. Fixed income will prove very challenged, should we be entering a cycle of higher interest rates. In such an event, investors will continue to see negative returns from bonds and their indexes. Given the outlook for inflation and interest rates, all investors should reassess their investment objectives for the asset class. In my next writing, we will examine Curran’s Portfolio for Income (PFI) and why now may prove to be a good time to reallocate your fixed-income investments to one with an investment objective to preserve capital.
Please feel free to contact your private wealth manager to discuss Curran’s views on fixed-income and the economy. A member of the Investment Committee will be available to discuss the topics further.
Co-CEO & Chief Investment Officer
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