Last year, 2022, was not kind to the bond market. In fact, it was the worst year ever for the U.S. bond market. according to Edward McQuarrie, professor emeritus at Santa Clara University. Inflation surged in 2022 and remains stubbornly high above the 2% target set by the Federal Reserve.
Will it remain high?
The bond market says “no.”
Could it be wrong?
Let’s start by examining what the bond market is telling us and conclude with a solution that will pay you and your clients to insure for the possibility of continued high, long-term inflation. Think of it as being paid to buy insurance.
Hypothesis failed
I assumed that the surging interest rates in 2022 were mostly the result of high inflation with the CPI running at 8% for calendar year 2022. Because of the inverted yield curve, markets said inflation would come down and the Fed would lower the overnight Fed funds rate that it controls. It does not control intermediate and long-term rates; markets control that. Case in point, between 12/31/2014 and 11/8/2019, the Fed raised the Fed funds rate by 1.5 percentage points and the 10-year Treasury bond yield declined. Markets did not believe high inflation was imminent.
The market was right, at least for a while.
My hypothesis was that the surge in intermediate-term interest rates was mostly due to higher inflation expectations. To test the hypothesis, I compared the real inflation-adjusted yield of 10-year Treasury Inflation Protected Securities (TIPS) to the nominal 10-year Treasury bond. Note how stable the differential was at roughly 2.42 percentage points, clearly proving my hypothesis was wrong. That differential was essentially the market’s prediction of future inflation over the next decade.
Why did real rates surge over the last 22 months? The best answer I’ve heard came from Boston University economist Lawarence Kotlikoff, who told me, “It’s a mystery.” I couldn’t agree more.
Shortly after my analysis, Morningstar’s John Rekenthaler wrote this piece showing the differential between the 30-year TIPS and nominal 30-year Treasury bonds has remained fairly stable at about 2.29% since 2004. In the chart above, the difference between the nominal and real rates is an estimate of the bond market’s prediction of future inflation for the ensuing decade.
I asked Professor McQuarrie how to interpret what the bond market is saying about inflation. He responded:
The expected inflation over the next 10 years has remained remarkably steady, despite the earthquakes in the bond market.
That steadiness means either:
- Despite all the ”sturm and drang,” nothing has fundamentally changed in terms of the factors driving U.S. inflation going forward; or,
- This is one of those times when the market has got it wrong, and it is illegitimately extrapolating forward from the recent past, as if 2.3% inflation was the usual, customary, reasonable state of affairs.
In fact, inflation that low, over decade plus periods, has been the exception not the rule.
I asked McQuarrie which of the two explanations he favored and he replied, “I think the bond market has it wrong.” Indeed, in a recent Barron’s article, Rob Arnott, the founder of Research Associates, said “Inflation is more of a risk than the markets give it credit for.”
McQuarrie showed me a chart he produced of historical inflation, based on rolling averages of inflation going back to 1944. Rarely has inflation been as low as the 2.42% forecasted by the bond market. Since 1944, inflation has averaged 3.57% annually and the 10-year rolling average has approached 9%.
How much has inflation cut the value of the dollar? McQuarrie states it was as much as 60% over 10-year periods and more than 80% over 30-year periods.
If history repeats itself, the consequences could be devastating. Rekenthaler writes:
If you firmly believe that modern central bankers will not permit a repeat of 1970s inflation, then you will likely be equally enamored with nominal bonds. I am not quite sure how anybody could outright prefer conventional Treasuries, though. Doing so would require substantial faith that long-term annual inflation will not greatly surpass 2.29%. That strikes me as the triumph of hope over experience.
If you think the worst-case scenario for bonds since 1944 is overly pessimistic, I repeat that 2022 was the worst year ever for the bond market. An analysis in 2021 looking at the worst-case scenario would have been too optimistic. Given the geopolitical risks, particularly in Israel and the Ukraine, and the amount of our national debt and deficit, we are in unchartered territory. We could have anything from hyperinflation to deflation, though McQuarrie thinks the latter is highly unlikely.
Being paid to buy inflation protection
The main purpose of a portfolio is to support one’s lifestyle. When it comes to Treasury bonds, the only thing that matters is how much spending power it supports. The nominal yield of 13.65% in a 10-year Treasury bond in 1980 was not a good thing. That’s because a large part of that return went to pay taxes, and the inflation rate was 13.5%. Spending power declined because the IRS taxes us based on nominal rates.
Clearly, if we have high inflation, TIPS, held to maturity, will do better than the equivalent nominal Treasury bonds. TIPS will have provided insurance against higher-than-forecasted inflation. Both, however, will suffer from decreased spending power, because our taxes are based on nominal, and not real, income.
But what if inflation is low, zero, or even negative? Sure, a nominal Treasury will likely outperform TIPS, but one’s spending power will actually increase. If inflation turns out to be zero (an unlikely, extreme case), then a $100,000 investment in a TIPS with a real yield of 2.5% will generate $2,500 At a 32% marginal federal tax bracket, that provides $1,700 of after-tax income, which (with no inflation) is the increase in spending power. Treasury bonds are state and local tax-exempt. But if inflation comes in at the historic average of 3.57%, that translates to a $6,070 pretax gain, or $4,128 after-tax for TIPS. With 3.57% inflation, the increase in spending power is only about $538. While counter-intuitive, one’s spending power increases if inflation is lower than expected.
TIPS and tulips?
One recent blog stated there was TIPS-ladder mania at the 2023 Bogleheads conference in mid-October. It was certainly a topic that came up multiple times. A 30-year TIPS ladder supported a 4.56% safe withdrawal rate as of November 18, 2023. It’s a great option for part of one’s fixed income allocation. I did this myself and built a $1 million TIPS ladder that, along with Social Security, provides an inflation-adjusted spending floor. Tulips were a mania in the early 1600s and were irrational. But TIPS are backed by the full faith and credit of the U.S. government and, if held to maturity, will best inflation by 2.3% annually. It’s a great option for part of a portfolio. Over-allocating to TIPS, however, can be dangerous and characterized as a mania.
Conclusion
I often advise people to “get real” as in focusing on inflation-adjusted returns after taxes. No one can predict inflation, but it’s certainly a big risk. “Inflation really is another form of longevity risk,” said Joel Dickson, global head of advice methodology at Vanguard in a recent New York Times article on how to protect your retirement against inflation. The bond market is saying the Fed will control inflation and remain far below historic averages. I typically don’t bet against markets, but this is one of the rare times I will by using TIPS as inflation protection. If inflation turns out to be high (heads), I win with TIPS. If inflation turns out to be low (tails), I win even bigger with more spending power due to paying less in taxes.
How long will real yields remain this high? Will they go higher? Those are questions to which I know I don’t know the answer. But TIPS rates are more attractive than in over a dozen years.
Allan Roth is the founder of Wealth Logic, LLC, a Colorado-based fee-only registered investment advisory firm. He has been working in the investment world of corporate finance for over 25 years. Allan has served as corporate finance officer of two multi-billion-dollar companies and has consulted with many others while at McKinsey & Company.
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Last year, 2022, was not kind to the bond market. In fact, it was the worst year ever for the U.S. bond market. according to Edward McQuarrie, professor emeritus at Santa Clara University. Inflation surged in 2022 and remains stubbornly high above the 2% target set by the Federal Reserve.
