March 29, 2021
“Let me tell you about the great bond I just bought!”
– Said no one, ever?…
If stocks are cocktail party chatter, bonds are a funeral dirge crossed with an 8 a.m. statistics lecture with a hangover. Stocks are sex and sunrises and tequila – surging share prices! explosive earnings! long-term upside! – and bonds are clipping coupons, 0.01% returns, and the frumpy guy in the corner drinking flat ginger ale.
Or, that’s what they’d have you think.
The reality – more in a moment on why you may not believe this – is that bonds are the far bigger story than stocks and are a foundation of the global economy. And they’re telling us now that inflation is on its way.
The ‘Bonds Are Boring’ Conspiracy
Yes, “bonds are boring” is what they – the entertainment-investment industrial complex, CNBC, your broker, or the shoeshine guy/Uber driver with a hot tip – want you to think. For most of them, bonds are a Hummer-sized blind spot. After proclaiming that yields and prices move inversely – the bond equivalent of “the sky is blue” – you’ll often hear a lot of mumblemumblemumble.
They also want you to be lulled to snores by bonds because selling stocks is bigger money. Own one of the biggest bond exchange-traded funds (“ETFs”), the $85 billion in assets iShares Core U.S. Aggregate Bond Fund (AGG), and pay an expense fee of 0.04% for the honor. Hold the SPDR S&P 500 ETF Trust (SPY), the biggest S&P 500 Index ETF (assets of $337 billion), and you’re hit with an expense ratio that’s more than double, at 0.09%.
That 0.05% is simply a rounding error if you own shares… but for BlackRock (which manages AGG) and State Street (in charge of SPY), that difference is worth $25 million in fees every year for every $50 billion in ETF assets.
That’s a big enough sum to make it worth encouraging some talking heads to forget about bonds… pay for more adds on the stock pages of your favorite investment-porn magazine… and entice brokers to nudge their customers away from boring bonds.
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The Power of the Bond Market
Bonds may not light the investment world on fire… But in the context of their impact on the economy, bonds are definitely not dull.
After proposals to boost the economy set forth in 1993 by the Clinton administration were confounded by anxiety over the reaction of bond investors, Democratic political strategist James Carville said this about bonds…
I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.
For starters, the bond market is 42% bigger than the stock market. According to the International Capital Market Association, as of August 2020 a total of $128 trillion in bonds globally were outstanding… compared with total global stock market capitalization of $90 trillion. (By comparison, the GDP of the United States last year – that is, total economic output – amounted to roughly $21 trillion.)
Bonds are big loans. When a company issues shares, they’re saying: Here, take this little slice of our company, give us cash in return, and if we feel like it, we may pay you a dividend… and if you feel like selling that little slice of our company – shares – to someone else, knock yourself out. When a company issues a bond, they’re saying: Hey, lend us some money, we’ll pay you interest along the way, and the whole sum back later on… and if you decide to sell your little part of that loan to someone else, knock yourself out.
Put together, bonds dwarf any other source of capital for companies and governments. If bank loans and stock issuances are squirts of WD-40 to grease the gears of business and commerce, the bond market is more oil tanker applied via hose to the entire economy. Without the bond market, lending – to expand businesses, to invest, to employ people, to create value in an economy – vanishes, taking the economy with it.
U.S. Treasuries are the global economy’s “risk-free” benchmark. The assumption is that the United States will always be able to repay its loans, and lending to the U.S. government – by buying its bonds – is the safest investment. So the yield that investors require of Uncle Sam when they’re lending him money is the foundation of all other interest rates for everything else.
A year ago, a 10-year U.S. government bond yielded 0.63%. Today, though, the yield is 1.63%. Yes, that’s only a 1% increase… like paying just another $10 per year on $1,000.
But in percentage terms, it’s a huge increase… more than 150%. This means that anyone who borrows money – a home mortgage, a pizza joint borrowing from a local bank to buy another oven, or Netflix borrowing issuing bonds to support its movie-making habit – will have to pay more, too. If the “risk-free” interest rate rises, all other interest rates move with it.
Why are investors demanding a higher rate of return from Uncle Sam? Like anything else, bond yields are driven by supply and demand. COVID-19 stimulus – at $6 trillion or so and counting – are paid for by more borrowing. The preliminary Biden administration that hopes to splash out trillions more on infrastructure, green energy, and other efforts is setting the stage for ever-greater levels of government bond issuances. When there’s so much more supply – or, anticipation of supply – the yield that investors can demand increases, too.
What the Bond Market Is Saying: Inflation
The other side of the equation is that if bond investors think the real (that is, post-inflation) value of a dollar tomorrow – when they’re repaid – will be less than they’re currently anticipating, they’re going to demand a higher yield. In other words, if investors are anticipating higher inflation, bond yields are going to rise.
As CNN explained earlier this month…
Investors are starting to worry that the economy may heat up too much, and that inflation will make an unwelcome return… Inflation is typically a bigger bugaboo when people have more money in their paychecks and are willing to pay higher prices for goods and services… The Fed has also given no indication that it’s ready to take its foot off the gas pedal and cut back on stimulus just yet either… It will likely tolerate more inflation as long as it is accompanied by an economic recovery.
In the up-is-down way that markets often work, inflation is actually precisely what the Federal Reserve wants. Last year the Fed announced a sharp change in policy to wait to hike interest rates – which in part drive bond yields and bank lending rates – until inflation is above 2% for a while.
Previously, the Fed would aim to increase interest rates in order to prevent inflation from reaching 2%. And now that it looks like the Fed might actually be getting what it wished for… markets are concerned.
Why the Bond Market Is Right
Inflation is, literally, what happens when prices go up. Prices rise when more money is chasing goods. And as the American economy opens up, two things are happening that will drive inflation.
First, people are getting cash – lots of it. The latest $1.9 trillion stimulus package will put fun money into the pockets of tens of millions of Americans. Some might use it to buy GameStop shares… or put it in the bank. But lots of them will use it to buy new kitchen cabinets… go to Disneyland… and visit Olive Garden a bunch of times.
According to a survey conducted by Bank of America in late February, 36% of respondents said they would spend their government stimulus cash. A quarter said they’d save it, and 30% indicated that they’d use it to reduce debt. The remaining 9% said they’d invest it.
Secondly – and more importantly – people want to spend money. As COVID-19 lockdowns in the U.S. ease, and more people are vaccinated, they’ll want to travel to get away from the walls they’ve been held pandemic-captive in… visit family… experience the Dolby surround sound, oversalted popcorn, and stage whispers of movie theaters… and order lobster and Champagne at the local sea food joint – in other words, do all those things that we haven’t been able to do and can’t wait to do again.
And young people might be the biggest spenders – if for no other reason than that more of them are living with (and thus eager to get some distance from) Mom and Dad than at any point since the Great Depression. According to Pew Research, in July, 52% of young adults (ages 18 to29) were living with one or both parents. That was up from 47% in February… and up from 38% two decades ago.
It may be just a question of time before inflation accelerates. During the 12 months ended on February 28, inflation rose 1.7%. But the S&P GSCI index – which measures the price changes of a basket of commodities – rose 33% over the same period. And it’s more than doubled since lows in late April last year.
Price rises in energy (53% of the index) and agriculture (19%), for example, may take time to filter through to Kroger shelves. And there’s always the question of how much of higher input prices producers will absorb – and how much they’ll pass on to consumers.
One of the best indicators of demand, and potential inflation, is your own experience. Have you been unable to rent a car lately because Hertz was fresh out of cars? Gone to the mall – and it felt more like Black Friday than a pandemic Tuesday? Waited in a line to get into a Kate Spade or Coach store alongside other “time to treat myself” folks? Struggled to get a reservation even for the local Red Lobster?
The people who set prices aren’t in the business of charity. They’ll be hiking prices soon enough… And that’s inflation.
Not So Boring After All
Sometimes the quiet guy in the corner is the one with the big brain who everyone will be working for in a few years. He’s not the captain of the high school football team (that’s stocks!)… Our dark-waters guy will be peaking a bit later in life when it really matters.
That’s the bond market – all the time. And just now, the quiet guy in the corner is raising his voice and he’s saying… inflation is coming. It would be smart to listen.
What should you do to protect your wealth from inflation? Reduce your exposure to the asset that’s losing value more rapidly now… In other words, get rid of some of your dollars. Swap them for assets that retain value (or lose it less quickly).
Holding cash in a bank – while yields remain microscopic – is like feeding your money to a fire-eating dragon. Buy gold… silver… or cryptocurrencies – all of which may well lose value, but it’s not a pre-defined, one-way trip down like it is if you’re holding on to your Ben Franklins. (Some people are buying NFTs, too.) Buy real estate – which (if you buy well) will retain value a lot better than cash. And of course, buy stocks – which are still rising, as part of the everything bubble.
Finally, if my story today has piqued your interest in buying bonds, Stansberry Research expert analyst Mike DiBiase has a bond investment publication, Stansberry’s Credit Opportunities. You can click here to learn more about this low-risk, high-upside way to add to your wealth and retirement.
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