Bond Bull?
January 15, 2010

The High Yield Market hit its all time high annual performance in 2009, up 57.5%. The next highest annual return was back in 1991, up 39.2%. Usually, record breaking market performance one year (2009) is followed by much worse than average performance the next year (2010).

Now some “experts” are saying “Get out before the bubble bursts” or “The US debt issuance is looking like a giant Ponzi scheme”, or “the Treasury yield curve is now the steepest it has ever been, which is signaling higher inflation”. Their message is bond prices are dangerously high and will crash.

There is no bubble. A correction? Sure, that’s normal. The bond markets will return about their coupon this year.

The yield curve is not signaling higher inflation. The yield curve is steep because the Fed has short term interest rates at zero. Clearly, the real experts expect no inflation or they would set short term rates higher than long term rates.

These apocalyptic warnings are all Bond Bull---t.”

Here’s why.

First, we all know short-term interest rates are controlled by the Federal Reserve. Long-term interest rates are determined by market forces. Thousands of investors make judgments on the best real rates of return they can achieve. This judgment includes an inflation expectation. Right now, inflation is 1.8% and the 10 year US Treasury bond yield is 3.8%. Subtracting the inflation from the bond yield gives you the real rate of return of 2%.

Unanticipated inflation is a bond investor’s greatest fear. This is because inflation greatly impacts the real return on all long-term fixed income investments. This includes Treasury bonds, investment grade corporate bonds, junk bonds and municipal bonds. If investor’s expect rising inflation, they will require a higher yield before investing. This means bond prices will decline in rising inflation environments and bond investors lose.

The following chart shows the past 100 years of inflation. There are two distinct periods. The 60 year period from 1913 to 1972 experienced very little inflation. The average annual inflation rate was 2.4%. And there were periods of deflation, especially severe in the depression years.

The 40 year period since the early 70’s has experienced steady inflation. The average annual inflation was 4.5%, almost double the first period. And inflation went up every year for the past 40 years.

However, for the past decade inflation has been slowing, averaging 2.6% a year. And for the past two years inflation has been declining, which is typical of recessions. The latest annual inflation is 1.8%.

The change from essentially low inflation to steady inflation was started by Lynden Johnson who thought he could have his “Great Society” (another name for welfare) and the Vietnam War at the same time. He couldn’t, and inflation accelerated to double digits by the late 70’s.

This was the beginning of a massive expansion of the government’s role in the economy and the now common entitlement mentality of many Americans. Until this stops and reverses, inflation is a given.

Is Inflation Rising or Falling?

The chart below gives us a close up on inflation and compares it with the 10 year US Treasury bond. As the red line gets close to the blue line an investor’s real return goes down, and when the red line is higher than the blue line, for extended periods in the 70’s and briefly in 2008, an investor’s real return is negative. In other words, investors lose money.

As you can see, inflation soared in the seventies to a high of almost 15%. Fed Chairman Paul Volker stopped it cold for a short time and Reagan slowed its growth in the early eighties. But inflation never returned to the low levels of the 50’s and sixties. Although it varies greatly from year to year, inflation has mostly settled into a range of 2% to 3% a year. The average for the past five years is 2.4% and the average for the past 10 years is 2.5%, and the average since 1983 is 3.0%.

You will note the long continuous time period the blue line remained far above the red line from the early eighties until now. The real rates of return to Treasury bondholders were massive. You will also note the 10 year Treasury bond has been in a sustained decline for 25 years. From a technical perspective this downtrend is still in effect.

The all time low of under 2% was achieved as investors scrambled for safety during the market meltdown of late 2008. The 10 year bond has since returned to a more normal level of 3.8%. I believe it will continue to trade in a range from 3.5% to 4.5%. At long term inflation of 2.5% investors achieve about a 1% to 2% real rate of return.

One of the elements that make inflation so variable is the cost of energy. So, let’s look at the same chart but without energy in the inflation calculation. And as the chart below illustrates inflation is less volatile and is trending down.

With or without energy, the inflation story remains the same. It will stay in a range from 2% to 3%. It is now 1.8% and will likely stay in the bottom part of its range this year, or about 2%. So, the answer to the question “Is inflation rising or falling?” is neither. It is staying about where is has been for the past 15 years.

The following chart illustrates investor expectations about the long term real rate of return. As you can see, the yield on the inflation indexed 10 year Treasury bond since this bond was issued in 2003 has been about 2%. It varies based on investor psychology. The yield declined to less than 1% in 2008 as investors fled the capital markets in search of safety. As the financial situation stabilized the yield returned to a more normal level. Recently the yield has been at the lower end of its range at 1.5%.

When we add our expected inflation of 2% to our expected real rate of return of 2% we get a 10 year bond yield of 4%. That is about where I think it will trade in 2010.

Some commentators are pointing to the rise in the price of commodities, such as gold and copper, as proof inflation is rising. Given the massive surplus resources of houses, workers, factories, and liquidity currently available in the economy, it seems unlikely inflation will accelerate. And the notion that commodity prices affect inflation is not confirmed by the data.

The following chart shows the massive run-up in prices of precious metals over the past ten years, and the run-up in all commodity prices. However, inflation, although highly variable has not increased. There simply has been no connection between commodity prices and inflation.

So let’s add this up:
- Intractable but steady inflation of 2%
- Massive surplus resources are available (read the details in What Recovery? What Recession?)
- Treasury Bond yields are in a long-term downtrend and leveling out around 4%
- Commodity price increases will not impact inflation or bond yields.
- There is no bubble. Bond markets will return about their coupon in 2010.

There are several reasons I believe the corporate bond markets will have a normal issuance and average return year. I will cover those in the next commentary.

May you live long and prosper.

Mike Williams, CFA
January 15, 2010

(back to commentary)