Fear of Soaring (Bond) Rates are Overblown?

[Midpack]

At over 40% bond fund allocation! I've been looking for some encouragement on this front lately FWIW.

For those concerned about the outlook for bond returns in the years ahead, one person's (Rick Ferri) view for your consideration. If you plan to read the articles, don't look at the quote below the links, it gives away the conclusion.

Fears of Soaring Rates are Overblown (Part 1 of 2)
Fears of Soaring Rates are Overblown (Part 2 of 2)

Individual bonds and bond mutual funds are going to deliver a punch sometime in the next few years, but it won’t be a deadly blow. I don’t have a good answer for what is coming, except to say that broad diversification helps, and don’t fight the Fed by trying to predict the timing of their balance sheet unwinding. We’re prepared to muddle through a difficult bond market in the same way we’ve been muddling through a difficult stock market since 2007 – diversify, rebalance, and stay the course.

Fed Chairman Ben Bernanke and the FOMC will likely begin unwinding their balance sheet in a slow and controlled manner starting around 2014. The process will reduce the total return of every bond portfolio over the next decade whether an investor holds individual bonds or mutual funds. Think of it as giving back gains that we should have never earned. On the positive side, I don’t believe rates will soar during the unwinding. This should make the reversal somewhat palatable, whenever it comes.

 

[Coolius]

I hold several individual corporate bonds in my IRA, laddered up to 2017. The way I see it, I am ensuring myself a fixed income for the next few years, so long as I hold the bonds to maturity ( which I intend to ).

So fluctuations in the bond value itself is not a factor in my decision to buy and hold bonds.

If bond values decline due to increasing rates, I will buy more bonds and continue to ladder in as my present ones mature..

 

[Chuckanut]

One would hope that if one owns a bond fund, or an income fund such as Wellesly, the management will take this into account and take the necessary steps to preserve as much capital as possible.

 

[clifp]

At over 40% bond fund allocation! I've been looking for some encouragement on this front lately FWIW.

For those concerned about the outlook for bond returns in the years ahead, one person's (Rick Ferri) view for your consideration. If you plan to read the articles, don't look at the quote below the links, it gives away the conclusion.

Fears of Soaring Rates are Overblown (Part 1 of 2)
Fears of Soaring Rates are Overblown (Part 2 of 2)

This is a good article and one of the better explanations of the Fed's move.
However, I think there are two potentially bad assumptions. First markets in bubbles seldom correct back to the fair value, they almost always overshoot on the way down, as has been witnessed many times since 99 and most recently in 2008/9 for the stock market and currently for the housing market.

Second and more importantly the underlying assumption in his calculations is that inflation will remain 2%. I find this pretty unlikely over the next decade with so many governments, burdened with debt, having a high incentive to inflate their way out of trouble. For instance we are already seeing wage inflation in countries like China, and impacting our Xmas presents prices. If we increase inflation form 2% to 4% this will result in additional 10% price drop in the total bond market fund.

But since in the short term bond yields are based on expectation of future inflation/interest rates, it is not hard to imagine to investors seeing inflation go from the current 2.1% to 4% make the assumption that inflation will hit 6%. This would mean an additional 10% drop in price (to 30%) at with current yield of 3.15% this would mean the potential for this decade to be the lost decade for bonds.

The almost 3 trillion dollars in bonds on the Fed's balance sheet is unprecedented amount, unwinding without depressing bond prices is going to require lots of skill, and ton of luck. To me the best case is that bond fund prices drop 10% over the next 4 or 5 year, worse case is probably 30% and likely case is 20%.

 

[heirloom]

unwinding without depressing bond prices is going to require lots of skill, and ton of luck.

I think this is why a lot of fund mgrs. are purchasing short term bonds, MBS, and overseas debt.

 

[Khufu]

Nope. No inflation on the horizon.

The inflation crowd has been dead wrong for years now and they will continue to be wrong for years to come. They are generals fighting the last war. With Europe headed into a recession and possibly the USl, too, it's hard to see a wage/price spiral getting started. Labor market participation has continued to decline in the US even with slow GDP growth. Inflation is not going to happen. At least not soon.

 

[clifp]

The inflation crowd has been dead wrong for years now and they will continue to be wrong for years to come. They are generals fighting the last war. With Europe headed into a recession and possibly the USl, too, it's hard to see a wage/price spiral getting started. Labor market participation has continued to decline in the US even with slow GDP growth. Inflation is not going to happen. At least not soon.

I'll plead guilty to being to early on my call for increased inflation. Still for the last 12 month CPI-U is up 3.5% closer to my 4% figure than the Ferri's 2%.
Furthermore one of the major components of the CPI is shelter which rose only 1.8%, for those of who own homes this is pretty much irrelevant (unless you are trying to sell the house....) Of far more importance is the 14.2% 12 month rise in energy prices or the 4.7% increase in food prices.

 

[Midpack]

Inflation is not going to happen. At least not soon.

I also thought we would see inflation sooner rather than later, but later is more plausible now than I thought. But with all the money we've printed (QE etc.), I don't understand how inflation can ultimately be avoided. Much of the money is still on the sidelines at banks, but that won't last forever.

I guess Milton Friedman has been proven wrong on some lesser points in the past few years, but I'm not ready to abandon his views on money supply and inflation - yet. That would really burst my bubble...but I've been wrong many times before.

 

[teejayevans]

I also thought we would see inflation sooner rather than later, but later is more plausible now than I thought. But with all the money we've printed (QE etc.), I don't understand how inflation can ultimately be avoided. Much of the money is still on the sidelines at banks, but that won't last forever.

As long as the Fed keeps interest rates low:

• Banks will borrow at 0% and turn around and make 2% by buying treasury notes instead of loaning the money out at considerable more risk.
• The housing market will stay depressed because everybody knows there is no end in site for low interest rate mortgages.

• Public will feel poor because they aren't making money on their CDs.

I think the Fed (once again) is mucking up the works but interfering with the free market.
TJ

 

[audreyh1]

I think the key is that it takes more than printing money to cause inflation. In the past things like pressures from wage increases or the ability of companies to pass along price increases to consumers were what ultimately drove inflation. Seems like we have the opposite situation now. In fact the Fed is so "easy" because they see deflationary pressures in our economy.

It would probably take a rip-roaring economy to get inflation to run hot again. Somehow, any developed economy taking off like a rocket seems pretty remote at present as global growth has slowed significanty and the developed economies are very busy deleveraging - i.e. trying to pay off/deal with old debts.

Audrey

 

[Hamlet]

+1

I'll plead guilty to being to early on my call for increased inflation. Still for the last 12 month CPI-U is up 3.5% closer to my 4% figure than the Ferri's 2%.

 

[Gearhead Jim]

I think the key is that it takes more than printing money to cause inflation. In the past things like pressures from wage increases or the ability of companies to pass along price increases to consumers were what ultimately drove inflation. Seems like we have the opposite situation now. In fact the Fed is so "easy" because they see deflationary pressures in our economy.

It would probably take a rip-roaring economy to get inflation to run hot again. Somehow, any developed economy taking off like a rocket seems pretty remote at present as global growth has slowed significanty and the developed economies are very busy deleveraging - i.e. trying to pay off/deal with old debts.

Audrey

I agree.

It is said that money has both "quantity" and "velocity". Right now the quantity is pretty high, but the velocity is near zero.

If the quantity can be reduced smoothly as velocity increases, then things could work out well.

If...

 

[MichaelB]

I think the key is that it takes more than printing money to cause inflation. In the past things like pressures from wage increases or the ability of companies to pass along price increases to consumers were what ultimately drove inflation. Seems like we have the opposite situation now. In fact the Fed is so "easy" because they see deflationary pressures in our economy.

It would probably take a rip-roaring economy to get inflation to run hot again. Somehow, any developed economy taking off like a rocket seems pretty remote at present as global growth has slowed significanty and the developed economies are very busy deleveraging - i.e. trying to pay off/deal with old debts.

Audrey

+1

The BLS released wage numbers this morning and reported that real average wages declined by 1.7% over the past 12 months. As long as wages are stagnating it is difficult to see inflation really picking up anytime soon.

 

[Khufu]

I also thought we would see inflation sooner rather than later, but later is more plausible now than I thought. But with all the money we've printed (QE etc.), I don't understand how inflation can ultimately be avoided. Much of the money is still on the sidelines at banks, but that won't last forever.

You don't understand because your model is "increase in money supply" = "inflation." Well, that's comfortingly simple and wildly popular, but it's been proven wrong. It's time to consider other models with better predictive value, such as "liquidity trap."

The Japanese increase their money supply by 1/3 in 2001/2002. They are still stuck in deflation. Financial crises result in long recessions and not inflation.

From an investment point of view bond funds that give a good yield will continue to be attractive for some time to come, particularly since equities are priced to give low returns for the coming decade.

 

[Htown Harry]

I enjoyed this analysis piece in The Financial Times, reviewing 2011 expectations versus what actually happened:

US Treasuries: Surprisingly sturdy - FT.com

Their analysis is largely limited to treasuries, with lots of emphasis on the recent European financial turmoil's impact on the demand for U.S. bonds as a safe haven.

The authors also conclude that rates are unlikely to pop up in the next couple of years.

(Side comment: Bill Gross is quoted. He didn't guess right this year, but I give him credit for not hiding from the press as the news got progressively worse for PIMCO's strategy.)

 

[Midpack]

You don't understand because your model is "increase in money supply" = "inflation." Well, that's comfortingly simple and wildly popular, but it's been proven wrong.

Nothing is ever as simple as it seems. I was listening to a Nobel Prize winning economist, who never said it was as simple as that either - silly me...

I thought the velocity point above was a good one though, something I came to understand later.

 

[Chuckanut]

+1

The BLS released wage numbers this morning and reported that real average wages declined by 1.7% over the past 12 months. As long as wages are stagnating it is difficult to see inflation really picking up anytime soon.

I tend to agree with this. My concern is the political not the financial environment. Politicians (current and future) may be tempted to get out from under the Federal debt load by inflating the currency so that a billion dollars is no longer worth a billion dollars. Remember what the late Senator Dirkson said, " A billion here, a billion there, soon you are talking real money!'

 

[youbet]

Isn't this "no inflation" environment great for us FIRE'd types? I'm loving it! Not needing to increase my annual withdrawal amount to sustain an equal standard of living from year to year is great!

Stop by the gas station to fill the tank and no need for extra dollars over prior years. Grocery shopping, same thing! Property taxes, hey the local gov't wants no more of my money than before! Utility bills, no problem! And the money the feds are saving by not having to grant a 3.6% SS COLA increase will help the politicians dig us out of debt! It's all good.........

For folks not yet fully FIRE'd........ When running FireCalc scenarios, are you remembering to override the "historical inflation" assumption with a "zero inflation" alternative? It increases your survival rate nicely so you should be able to check out of the working world much sooner.

 

[youbet]

Still for the last 12 month CPI-U is up 3.5%.

Can this be correct? We are being crushed by deflation and must do everything possible to reverse it! How can the general price level have increased by 3.5%? BS!

 

[Mulligan]

Can this be correct? We are being crushed by deflation and must do everything possible to reverse it! How can the general price level have increased by 3.5%? BS!

The 3.5% is definitely the reality of the past 12 months ( though on the things I spend money on it seems more). But the expectations of the current and immediate future are less. Ive noticed the past 2 months the government has inflation at minus .1% and flat . Those are the first 2 months of the coming I Bond reset rate. Not looking good for my I Bonds come May!

 

[youbet]

The 3.5% is definitely the reality of the past 12 months ( though on the things I spend money on it seems more). But the expectations of the current and immediate future are less.

Your expectations for future inflation may be less, but not mine. I believe we're going to continue to see a brisk inflation rate in the 3% to 4% range. In particular, I'm planning on paying more for energy, food, health care and taxes over the next few years.

 

[Mulligan]

Your expectations for future inflation may be less, but not mine. I believe we're going to continue to see a brisk inflation rate in the 3% to 4% range. In particular, I'm planning on paying more for energy, food, health care and taxes over the next few years.

Actually, I agree with you, as I trust my true cost of living more than CPI figures, as that is what is most relevant in my life. As far as predicting bond movement in realtion to all of this... Its above my pay grade!

 

[youbet]

Actually, I agree with you, as I trust my true cost of living more than CPI figures, as that is what is most relevant in my life. As far as predicting bond movement in realtion to all of this... Its above my pay grade!

Me too!

It's entirely possible, as demonstrated this past year, to have inflation in the prices of things we spend money on everyday (food, energy, health care, taxes, etc.) while wages stagnate and interest rates on CD's, treasuries and such are very low.

 

[Khufu]

Me too!

It's entirely possible, as demonstrated this past year, to have inflation in the prices of things we spend money on everyday (food, energy, health care, taxes, etc.) while wages stagnate and interest rates on CD's, treasuries and such are very low.

There are a couple of things going on here. The inflation rate for retirees is expected to be higher than that of the general population largely because retirees use more health services which have a higher inflation rate as we all know. But the other effect is that people overestimate their own inflation rate because of the "availability bias" of some data, such as food. The average US household spends only about 8% of its income for food. So, even if food prices do go up somewhat faster than other costs it is not likely to affect the whole household budget that much. However, people make a lot more food spending transactions in a month than they do health care or housing. So, they recall the food transactions more readily and overweight them in estimating their total inflation rate.

The US cumulative inflation rate for the last three years has been about 4.5% or 1.5% per year. Not high.

 

[Mulligan]

There are a couple of things going on here. The inflation rate for retirees is expected to be higher than that of the general population largely because retirees use more health services which have a higher inflation rate as we all know. But the other effect is that people overestimate their own inflation rate because of the "availability bias" of some data, such as food. The average US household spends only about 8% of its income for food. So, even if food prices do go up somewhat faster than other costs it is not likely to affect the whole household budget that much. However, people make a lot more food spending transactions in a month than they do health care or housing. So, they recall the food transactions more readily and overweight them in estimating their total inflation rate.

The US cumulative inflation rate for the last three years has been about 4.5% or 1.5% per year. Not high.

Looks like Im about average as I spend about 8% (of net income). Am I correct in assuming government factors in consumer substitution of products in inflation formula? If that is true, then my inflation is higher, because I refuse to substitute my hamburger for chicken gizzards!