The Weekly Update 1/14/2022

Bonds are Under Pressure

Last week, 1/3/2022 through 1/7/2022, the U.S. Federal Reserve released the minutes from their prior meeting.  There was conversation in the minutes where the Fed governor discussed slowing down their purchases of bonds much faster (a known), increasing interest rates sooner than originally stated (a known) and reducing the size of the Fed’s bond holdings (an unknown).

Markets don’t like surprises (unknowns).  Long dated Treasury Bonds dropped 4%, which would have been the sixth worst “entire year” on record for the index going back 46 years to 1976!  That 4% reduction was the result of just a ¼% increase in the 10-year yield (Source: LPL Research, Daily Market Update 1/11/2022).  A 16:1 loss ratio!

This is exactly what I was warning fixed income investors about in The Weekly Update I wrote and posted to the WSG website on 11/12/2021.  I have pasted it in below with the lesson du jour in bold text.

The Weekly Update 11/12/2021

In The Weekly Update I wrote and posted to the WSG website for 10/29/2021 (read it here) I went into the root cause of the 1970’s inflationary period.

In the few short weeks since that post, the new monster the press is scaring readers with is “stagflation”.  Stagflation simply implies the economy is growing at the same rate as inflation, thus the economy is stagnant, i.e., not contracting, nor expanding, just churning.

Back in the 1970’s the Fed fell victim to what I referred to in the early 1980’s as “The Real Return Illusion™”!  The Fed did increase interest rates to 8%.  At that time, they believed they were slowing the economy down.  That’s how the Fed does it, slow economy, reduce interest rates to induce growth or economy growing too fast, increase interest rates to slow it down.

However, at the time the Fed goosed interest rates up to 8%, inflation was running at 10% - 12%.  When interest rates are 8%, to borrow and invest in say, real estate as an inflation hedge, where you would get the 10% - 12% return “real” interest rates were still too low.

Then Paul Volcker became Fed chair and he understood “The Real Return Illusion” and steadily increased interest rates up to 20%.  He clearly understood the interest rate to borrow money had to be higher than the inflation rate, so borrowing at 20% to make 10% - 12% was not a good “real” return, the borrowing and buying of inflation hedges stopped.  It worked!  Inflation was to wind down for the next forty years – until now.  However, in the process bond investments were decimated and personal bankruptcies hit all-time highs.

The lesson here is simple!  The Fed will, at some point, need to jump rates up above the inflation rate, which is currently +6.2% over last year, and the highest since 1990.  (Source: LPL Financial Research)

No one knows the future, yet it would be reasonable to suggest that interest rates will need to move higher than the inflation rate of 6.2% to kill “The Real Return Illusion” once again.

Take away:  If you own bonds, ask yourself why.  Bond investments are like a teeter totter.  Interest rates on one end (at nearly all-time low interest rates) and the dollar value on the other end (at nearly all-time highs).  Should the Fed start to get ahead of The Real Return Illusion, hypothetically, a 30-year bond would drop 12% in dollar value for each 1% increase in interest rates.

For this hypothetical example, let’s say the Fed lets rates increase to 8% from the current 2%.  That 6% increase could potentially reduce the market value of a 30-year bond by -72%.  That would be a realized loss of 72% should the bond holder sell.

You didn’t think that could happen?!  I have seen it with my own eyes in 1983.  It can happen.  Take the action you need to, but start with the “why do I own this bond investment” question!

As always, our team and I are available to discuss this concept with you.  Just call, email or stop by the office and say “Hi”!

Respectfully,

James O. Lunney, CFP®

CERTIFIED FINANCIAL PLANNER™ Professional  

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.  Investing involves risk. Loss, including loss of principal, may occur. No strategy assures success or protects against loss. All performance referenced is historical and is no guarantee of future results.  All indices are unmanaged and may not be invested into directly.