Troublesome Environment for Domestic Bond Investors
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The conventional wisdom views investment grade bonds as conservative and safe investment in any climate. Historically, however, that has not been the case. Bonds tend to perform poorly in market environments that are characterized by increasing interest rates. The two primary forces that determine the direction of interest rates are the Federal Reserve’s monetary policy and the bond market. Of course the “fed rate” can be set at the deliberation of the Federal Reserve Board, which tends to have an impact on the bond market. However, at the end of the day, the bond market beats to the drum of market forces (i.e. the supply and demand for bonds). This has become quite evident in recent weeks as the Federal Reserve has held the Fed rate steady while the bond market has driven the 10 year treasury yield markedly upward. The bond market has been pushing yields higher because fickle bond investors are requiring higher yields. As a result, the market value of existing bonds have fallen significantly.
Rising rates and the sell off in the U.S. bond market can be attributed to a variety of factors but the main culprit is inflation. Inflation, by definition, is an increase in amount of currency in circulation (money supply). Uncontrolled increases in the money supply can lead to rampant inflation. Unfortunately, the FED has been pumping greenbacks into circulation like there’s no tomorrow.
Of course, each new dollar in circulation erodes the purchasing power of currency already in circulation. Therefore, more and more dollars are required to purchase the same amount of goods and services. Eventually, inflation manifests in the form of rising consumer prices. But if you are watching the consumer price index (CPI) and the producer price index (PPI) for signs of inflation, you will not find much evidence. These statistics are unreliable for reasons I will not discuss for fear of sounding like a conspiracy theorist. Suffice it to say that much of the deception imbedded in these statistics is in how numbers are reported. The financial press tends to dismiss the overall CPI numbers and emphasize “Core CPI” which strips out food and energy prices. The last time I checked, food and energy prices have a profound impact on the average consumer. Most assuredly inflation is present in our economy. If you want proof, just take a look around. You are paying higher prices for oil, unleaded gas, food, housing, and many other goods and services.
Unfortunately, inflationary forces are likely to pressure interest rates, depress bonds, and the debase the U.S. dollar for many years. You don’t have to take it from me. A few days ago on CNBC, Bill Gross of PIMCO Funds, manager of the world’s largest bond fund ($94 Billion) declared the end of the 20 year secular bull market in domestic bonds citing his long-term outlook for inflation and higher interest rates. Only time will only tell if he is right. However, warning signs should flash when a man, who makes his living managing a $94 billion bond portfolio, publicly announces that serious challenges lie ahead for bond investors.
Now that we know why bond prices are falling, the question is “who’s selling?” Well, it may be less a matter of increased selling pressure, and more a matter of decreased buying interest on the part of foreign investors. For several years, foreign investors have provided a substantial source of demand for U.S. treasuries and other domestic debt securities. Much of that demand has stemmed from Chinese and Japanese governments who were buying U.S. debt securities in order to support their export lead economies. You see, by buying our U.S. treasuries, Japan and China were artificially depressing the value of their currencies thus making their products inexpensive for U.S. consumers. In other words, they made products, priced them cheaply, and sold them to Americans on credit. American’s now owe the rest of the world $ trillions. This debt is affectionately referred to as the “trade deficit.”
There was method in their madness, but Japan and China may be second guessing the wisdom in owning such a large pile of U.S. debt. In fact, a few weeks ago, China publicly announced intentions of diversifying their massive position in U.S. Treasuries. Coincidentally, foreign purchases of U.S. treasuries slowed sharply over recent weeks.
Yes, I believe troublesome times lie ahead for domestic bonds. It’s time for investors to look elsewhere.
