Bonds. Let’s talk bonds. Interest rates are climbing, and that translates to bondholder losses. You’ve seen them on your statement, but we are getting increased yields. So, what’s the bottom line?
Inflation has caused interest rates to climb. The fed’s fighting it relentlessly, and when interest rates climb, bond yields are expected to go up with them. And when bond yields are expected to go up, fixed income bonds lose value. This is textbook material. Interest rates go up, bonds lose value. So, with interest rates, there’s been an interesting phenomenon. Long term bond rates are not going up as much as we would expect, same with intermediate, given the severity of the hikes.
What this means is that the losses actually could be worse, and they’re not. It also means that the market feels these rates are coming back down, and that inflation is going to be under control. Else, those long bonds, the interest rate increases, we’ve gone through the roof right now. There’s a bunch of different predictors for future inflation, but probably the most accurate one is the Cleveland Fed 10-Year prediction.
Right now, it’s two and a half percent. Two and a half percent is a long way from the eight, nine percent we’re seeing now. Yes, the headlines come down to eight, core inflation really hasn’t budged yet, but there’s a big discrepancy here. What does this mean for investors? First, it means almost certainly, as we get this under control, interest rates are going to come back down, and bond funds and bond ladders, which both act almost identically, will recover. Individual bonds are a little bit different. They just kind of expire and die, and that’s its own story. We’re also returning to the paradigm of long-term falling interest rates. For centuries now, we’ve seen interest rates fall, and this is because the capital available to the ingenuity that exists, keeps increasing over time.
We’re not seeing that short-term, but we have no reason to believe that the long-term trend will not continue. In fact, the risk-free interest rate by 2050 is expected to be globally at 0%. I mean, that presents its own challenges down the road, and obviously they won’t keep going further and further negative, but the point is, the trend is your friend on this.
So let’s think this through. We’ve got rising interest rates, we’ve got valuations getting pummeled, and we got an environment where we expect a correction, where we expect probably a recession, where we expect global pressures to lessen, inflation to drop and interest rates to fall. This is the story. This is the dialogue that we’re expecting. What does that mean? That means there’s going to be a reversion. There’s going to be a reversion of this drop in values. The equities will recover, real estate will recover, bonds will recover.
What we’re looking at is one of those beautiful environments. In the next six to 12 months, it’s going to be a buyer’s market for the world. Everything is going to be on sale. And if you are a long-term investor, that’s what you should be hoping for. Sooner or later, these interest rates will come down. Sooner or later, the ascendancy of the dollar will correct. The dollar’s a zero-sum game.
And over time, as interest rates do come back down, everything that’s denominated overseas is going to do even better. So not only are we about to enter a buyer’s market, if we haven’t already, but double that statement, for international equities, international bonds, international real estate. Now, what can go wrong? The numbers don’t come down as much. Interest rates don’t come down as much. The trend may be your friend, but it may continue to blip for a while.
Well, yes, if infrastructure demands are greater than anticipated, which is possible, we have aging infrastructure, we have climate mitigation, infrastructure needs, we have… If there are other unexpected demands, then interest rates and inflation may not come down as much as anticipated. In fact, I’ve said before, I’d be surprised if it drops much below three percent. Three instead of two and a half is still well below where we are today. Slightly higher, long-term inflation and interest rates doesn’t hurt the thesis, so much as it slightly mitigates the upside. Most models suggest, add one percent for the worst-case scenario, to these long-term numbers. It’s still a whole lot better than where we are today.
- “Since 1311 Bond Yields Have Fallen with Metronomic Regularity.” The Economist, The Economist Newspaper, https://www.economist.com/graphic-detail/2022/10/06/since-1311-bond-yields-have-fallen-with-metronomic-regularity.