Are bonds an obvious investment now, if you believe that we will return to the 2010-1019 interest rate regime?

[daniellea]

Bonds are historically mediocre at returning positive real yields, which is why I've avoided them. But it seems to me that using bonds to bet on an interest rate reversion seems promising.

Here are the premises, as I see them:

• 30 year T-bonds are paying 4.45%
• The Fed is seeking to return to 2% inflation. During the 2010-2019 pre-covid era, at this inflation level, 30 year bond yields were about 1.5-2%
• There are good reasons to believe that the current episode of inflation is an economic readjustment from covid era shifts in demand, not a consequence of pre-covid low rates.
• If I use the zero-coupon bond equation value for interest rate r, par value V, years Y: Price=P=V/(1+r)[sup]Y[/sup] I get the following 30 year 3-year-holding period nominal-dollar profits for holding bonds through an interest rate shift from rate r1 to r2, as Profit = [(1+r2)[sup]Y-3[/sup]/(1+r1)[sup]Y[/sup]]-1
  • +116% profit if 30 year bond rates drop to 'normal' level of 2% after 3 years
  • +66% profit if 30 year bond rates drop to 3% after 3 years
  • 1.2% loss if 30 year bond rates rise to 5% after 3 years
  • 23.5% loss if 30 year bond rates rise to 6% after 3 years
  • 40% loss if 30 year bond rates rise to 7% after 3 years

If one is afraid of inflation during the holding period, one could pay a similar game with TIPS, which yield over 2%, but for recent history have tended to cluster around 1%. In this case, buying TIPS at 2% and selling in 3 years at a 1% rate would yield a 38% real-dollar profit, or about 11% a year.

Personally, I think that it is far more likely for rates to hold steady or fall back to 2%, because the 2009 to 2020 2% inflation era seemed to work OK economically.

So under this reasoning, the sensible strategy might be to bail out of stocks, pile into long-term T-bonds, and get back into stocks if and when stock prices (P/E) readjust to more closely reflect the traditional 4% equity risk premium, roughly P/E=1/(2% real bond yield + 4% equity risk premium )=17. Or even if P/E doesn't fall, holding bonds through an interest rate decline would give one a lot more money to put into modestly historically overpriced stocks.

edit: obviously, title is wrong - "2010 to 2019 interest rate regime"

 

[kupoin]

@daniellea I don't believe we are going back to QE anytime soon.

 

[daniellea]

@kupoin The fact that QE drove down long term rates is a solid point.

However, it looks to me like the Fed stopped piling on assets after 2014, and resumed only during Covid. The wikipedia article on QE seems to confirm this.

So it seems possible that the 2014-2020 era represented a natural 2% rate.

edit: now if we don't return to the low-rate 2010s era, it seems to me that a key driver of high stock prices will be gone. Suddenly, the safe alternative to stocks is yielding a real 2% instead of 0% (again, assuming either TIPS, or a return to 2% inflation).

 

[resjudicata]

@daniellea Except no. Inflation was stable and rates were far higher at many other points in time. The last decade was an extreme aberration, not the norm.

 

[daniellea]

@resjudicata Here is a Fed chart of 10 year rates minus inflation, from 1962 onward. It looks to me like sub-2% real bond yields were pretty common (1965-1980, 2000-2008, 2009-2020). So I'd say that real rates are at the upperish-end of what they've been, if we assume a reversion to 2% inflation. This ignores the high rates of the 1982-1988 Volcker/Reagan era.

 

[birdlegs]

@resjudicata Interest rates have declined for 800 years... It is not an aberration.

 

[daniellea]

@birdlegs You got downvoted, but here is Eight centuries of global real interest rates, R-G, and the
‘suprasecular’ decline, 1311-2018., by Paul Schmelzing of Harvard, Yale, and the Bank of England.

On page 13, the sideways graph shows a nominal rate trend from 15% (year 1310) to about 0% (year 2018).

On page 14, the graph shows the headline GDP weighted real global rate from about 13% (1317) to

 

[birdlegs]

@daniellea Exactly, thanks for this. We have some folks that make investment decisions based on feelings, rather than objective, academically-driven data.

 

[meghagupta]

@kupoin Define soon. The Fed started playing with fire by doing QE to stimulate (2010+) and not just to prevent a depression (2008). So far, they seem to think they have been quite successful.

 

[godhelpme1999]

@daniellea Consider that 201-2019 fed fund rates were the outlier, not the norm.

 

[daniellea]

@godhelpme1999 That's possible.

The 'mature economy' argument says otherwise: as outlined by Krugman, drawing on Swedish economist Knut Wicksell, for 30 years we've been heading into a low growth era where the natural rate of real interest is at or below the GDP growth rate. It's only young booming economies that can sustain higher rates (if you buy into this model).

Anyway, if the low rates of 2010-2020 were the exception, does this mean that the high stock P/E that they enabled (bonds are awful; must buy stocks!) are also the exception?

Ie, is the flip side of your prediction of a permanent return of high rates a sharply falling (or long-stagnating) stock market, as both rates and P/E return to historical norms?

 

[godhelpme1999]

@daniellea

Anyway, if the low rates of 2010-2020 were the exception, does this mean that the high stock P/E that they enabled (bonds are awful; must buy stocks!) are also the exception?

I personally think so - but one could just look at the fed fund rates and instead conclude that negative interest rates are next and high P/E will continue.

I think any heterodox investment strategy planning ten years or more out needs to consider how the federal government will belatedly address escaping a debt trap. Some potential scenarios involve "inflation tax".

 

[hmd]

@daniellea As another commenter mentions, long duration yields are definitely undervalued, even with the inversion. I mean I think corporate bonds with maturity in 5-10 years are probably the best way to play this to minimize inversion, while capturing a good amount of benefits from rates falling to 3.50%-4.00% FFR over the next 1-3 years, thats what the market is saying anyway

 

[daniellea]

@hmd Corporate bonds yields are about 5%, up from 3.7% around 2016, in agreement with your 3.50%-4.00%.

So applying the bond equation, buying 10 year bonds at 5%, and selling at 3.7% in 3 years, I get a profit of 26% over 3 years assuming zero coupon.

What is the advantage over using longer duration T-bonds? Is it to avoid the low-probability risk of rates rising even higher?

 

[hmd]

@daniellea No it’s just if u do some fixed income research, you can buy bonds that are say BBB rates and yield 6.5% for what is a pretty safe business model and lower risk than implied by the credit rating. This increases return significantly.

Edit: Oh sorry i missed part of your question, the point of using longer term treasuries would be to increase duration and interest rate sensitivity, make a downwards move in rates have a larger impact on bond value.

The problem is that unlike a normal environment, the longer the maturity, the Lower the yield and so you really want to balance duration for it not to be too longer that yield is impacted and your taking on too much interest rate risk, but also not too short as you still want that yield for a good amount of time and your willing to take some interest rate risk for upside in 3 years.

 

[resjudicata]

@daniellea Just because inflation may be gone soon doesn't mean we are going back to the previous ultra low rates and QE. Your entire analysis is based on a fallacy. Compared to various points in history, interest rates right now are actually still fairly low.

 

[nicolalalala]

@resjudicata

Compared to various points in history, interest rates right now are actually still fairly low.

1) Fed funds at 0 was a recent development sure, but FFR was lowered to 3% in 1992-1993, and 1-2% between 2001 and 2004, much lower than they are now. Cutting rates without a major 2008-like event is not unprecedented.

2) OP is talking about long duration yields anyway, not directly a function of ultra low short term rates. Long duration yields have gone down for decades, way before 2008 introduced creative monetary policy tools. This was due to declining population growth and diminishing marginal returns across the developed world. For long duration yields to not only stay where they are but actually meaningfully increase, one should expect a reversal of these trends. There is a reason for interest rates being historically low and just because it was high before doesn't mean it will somehow go back to the highs for no reason.

 

[daniellea]

@nicolalalala

Long duration yields have gone down for decades, way before 2008 introduced creative monetary policy tools. This was due to declining population growth and diminishing marginal returns across the developed world.

Yes. See this NYT Krugman article.

 

[daniellea]

@resjudicata

Compared to various points in history, interest rates right now are actually still fairly low.

Here's the 10 year T-bond rate minus inflation from 1962. If you believe that T-bonds will stay at 4.3%, but inflation will fall to 2%, then today's bond rates are pretty typical. In the 1960s 10 year T-bonds yielded 2.5% to 2% above inflation, then went negative from 1975 to 1980, then rose to 7% for a very brief time, then hovered at around 3-4% to late 1990s, then went below 2% from 2000 to 2009. So real rates are low today only if we believe inflation continues, but if we believe inflation will return to 2%, then rates seem pretty normal for the post-1960 era.

 

[nicholasb]

@daniellea Great post, this kind of discussion is needed for sure.

My belief is that central banks will overshoot their interest rate hikes. Because how could they not? The feedback loop dynamics of the economy are not fully accurately modelled by anyone, it is an impossible task. But I think it's reasonable to believe that the delayed & cumulative effect of all the rate hikes won't be apparent until much later, resulting in a very delayed economic signal being read back. Delayed feedback systems tend to be very difficult to control.
So if one believes rate hike overshoot is likely, then that same person may also believe that bonds are an obvious investment right now