The changing macro environment of the U.S. economy over the last 60 years has created a current state where we are still benchmarking past anomalies with current potential results. To simplify this, we still have extreme events of the 1970s and early 1980s as the potential for interest rate and inflationary shocks, though those have been shown to be anomalies.
We have many articles touting the bond bubble that is coming; however, it is important to deconstruct how a bond bubble bursts versus that of equity or housing. Bonds, for the most part have a maturity date and par level upon its termination. Equities, Housing and commodities do not have such characteristics. This single difference creates a more interesting dynamic and reveals the cyclical nature of debt pricing inside longer secular moves.
We illustrated this in the past when we discussed inflation rates as an average and their standard deviation, or volatility of the inherent number. Recall last year we pointed out that inflation was showing significant dynamics than years gone by (click HERE to view piece).
“During the first 50 years, one notices that Consumer Price Index (CPI) averaged 2.50% but was extremely volatile with a standard deviation of 6.50%. Compared to the last 49 years, CPI averaged 4.20% (68% higher) but much less volatile with a 2.6% standard deviation. Even more dramatic is in the last 25 years the CPI has averaged 2.90% with a standard deviation of 1.32%. This stability has allowed the Federal Reserve to focus a bit more on the dual mandate versus emphasizing more singular price stability.”
Inflation is often seen as a result or a catalyst toward impacts on interest rates depending upon which economic camp you reside in. However, the inflation numbers shifting have also been corroborated by some broader measures. The Federal Funds rate had a standard deviation of 2.84% from 1971 to 1985 and a range of 16.505 (low of 3.50% to a high of 20%). From 1985 to current the standard deviation has been 1.58% (or a 45% decline) and a range of 9.50% (low of 0.25% and a high of 9.75%).
What is significant about the volatility features is the severe micro managing of the Fed Funds rate that Chairman Volker undertook while trying to get inflation under control. In the two and half years he took over, the Fed Funds rate went from 10% to 20% in less than six months, only to drop to below 10% a few months later and back to 20% by the summer of 1981. Consequently, the Federal Reserve has learned that lagging and maintaining policy is far more conducive to overall effectiveness versus micromanaging interest rates and causing more volatility when reducing volatility is a primary function.
Another measurement which has seen the same shift is the year-over-year change in consumer credit. In the 40 years from 1945 – 1985 consumer credits year-over year-change had a standard deviation of 9.4%, while the last 37 years has been 4.4%. The interesting dynamic of this is the discussion that always seems to come up at our AAM University sessions. What is velocity of money telling us about inflation? In a nutshell, it is bordering on an obsolete measurement with the advent of credit card usage over the last 20 years. It was used as an indicator that inflation was imminent when the number rose; however, it has lost much of its meaning as payment has differed. We could actually see a bit of an uptick on this should the conservative nature of consumers continue. However, we would not put much credence into it.
*M2 is the total money supply aggregate that is measured by the Federal Reserve.
As a result of the many dynamics of the modern economy coupled with a more mature and developed overall economy, the discussion of a bond bubble bursting should be put in the right frame. Most agree that interest rates will rise over the long term and we would agree with that. However, because interest rates are adjusted by the Federal Reserve depending upon what they are trying to achieve, you find that interest rates cycle with the economy and that creates a ceiling and floor to bond portfolios during these shifts.
The following chart shows the U.S. 10-year Treasury between 1962 and 1980 with arrows showing periods of interest rates rising (red arrow) and declining (green arrow).
We used this timeframe since many are discussing a secular move akin to what led to the move in the 1970s. It took 18 years for the 10-year Treasury to move from a sub-4% to over 12%. In between then we saw four upward cycles in interest rates and three moves downward. Just as we see in most markets, the downward moves are more pronounced over a short timeframe and the longer upward trends took longer. What this details is that for those bond investors who have low to moderate duration, you will more than likely see your fixed income portfolio turnover two to three times during a secular move. As such, the best way we see to control duration in the current environment is to increase coupon as much as possible. See Mark Gregg’s blog post on purchasing premium bonds for more detailed analysis.
What it also reveals is that permanence and definition in a portfolio is as important as ever. Knowing what you have, the cash flow generated and when bonds will mature is crucial to taking advantage of the cyclical nature of interest rates inside a secular bear market.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog. For additional commentary or financial resources, please visit www.aamlive.com.