The Great Bond Market Deception

May 18, 2023

What’s the best investment when times are tough?

Morningstar asked that question in an article last week. They asked it because: 

…surging interest rates have given rise to another worry: Could the Fed overshoot on interest rates, pushing the economy into a recession along the way?

To answer it, they did a study that examined the returns of stocks, bonds and various combinations of holdings. Not surprisingly — in seven of the eight economic contractions they identified — bonds proved to be the best performers.

Source: Morningstar

But there’s more to this story than meets the eye…

Bond Returns Actually Suck

Granted, a nominal annual return of 3% is certainly better than a nominal return of 1%.

But, and this is important for investors to understand, all your returns need to be considered through the prism of inflation. In other words you want to know what your real returns are.

I’ve explained this before. If you earn 4% on an investment in an environment where inflation is running at 5%… you’ve actually lost 1% of your wealth.

And lately that has been more and more important to consider because inflation has been killing bond investors.

For the better part of the last 15 years, (actually since the “tech wreck” in 2000) the Fed had given in to a policy of easy money. They did this ostensibly to “stimulate” the economy. In reality all they did was create inflation.

Which wasn’t all bad. While the price of your groceries were going up, so were the prices of your stock portfolio and your house. Everybody got a little bit rich. Using the S&P 500 as a barometer and scratching out some very rough math, investors made 28% in 2019, 16% in 2020, and 24% in 2021.

But now, thanks to soaring secular inflation, the free money party has to end. And the assets that were making everyone rich before are…   

Well, like Warren Buffett says, when the tide goes out, you find out who’s swimming naked.

And during that period of easy money, bond investors have gotten killed. Take a look at the two charts below. The top one shows 10-year bond yields vs. inflation. The green line shows the real return on the investment. For the better part of that 22 year period, a 10 year investment of your money earned you somewhere around 1.5%.

Source: The Federal Reserve Bank of St. Louis

The second one is even worse. It shows 2-year bond yields vs. inflation. For the better part of 20 years, real returns have been negative!

Source: The Federal Reserve Bank of St. Louis

What’s an investor to do?

The Question is the Answer

Remember the simmering question that kicked off this whole discussion? Whether the Fed could overshoot on interest rates and push the economy into a recession?

It’s not a question of if they could…  they have to!

In a normal economy, interest rates are supposed to trade above inflation. Here’s a couple decades of decent returns.

Source: The Federal Reserve Bank of St. Louis

But when that relationship inverts, something needs to flip it back. Ordinarily, the market would fix the problem on its own — capital seeks its highest return — but we have the Fed who has to be in charge. So now it’s up to them.

The closest parallel we have is the “Great Inflation” of the 70s and 80s. Check out one more chart below…

Source: The Federal Reserve Bank of St. Louis

Inflation began to heat up in 1972 and by 1974 inflation had soared past treasury yields. The Fed tried to tackle it by ratcheting up rates right into the middle of a recession. Funds backed off and inflation cooled a couple months later. 

But by 1977, it was heating up again. This was the spike that made Paul Volcker famous. The Fed spiked rates into 1980 which predictably caused a recession. But as soon as the recession began to ease, he turned up the heat again. The hike in the funds rate pulled yields on everything back north of inflation. Real rates all flipped back positive. 

You might want to take note… it didn’t take one, but two, recessions to get that bout of inflation under control.

It’s gonna take some tough times to make bonds a good investment again.

Make the trend your friend,

Bob Byrne
Editor, Streetlight Daily