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.
|For interest rates to rise and stay there, faster inflation is, and has always been, the key factor.|
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.
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.