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Fed actions to fight inflation by raising interest rates have not in fact increased interest rates. It’s a puzzle.
Last month I advised abandoning stocks and bonds in favor of inflation-protected alternatives. That hasn’t worked out. I have not changed my mind. Interest rates will increase and cause losses in stock and bond markets.
Last month I wrote How I Protect Against the Coming Market Crash, summarized as follows:
- Interest rates are going up, so bond and stock prices are going down.
- You can ride it out, but it could be an awfully long rough ride.
- The other option is to move out of stocks and bonds and either (1) hold other assets or (2) hedge your stocks and bonds
July 2022 has put egg on my face. Interest rates have decreased and the alternatives I recommended have suffered serious losses.
My apologies to anyone who has taken my advice so far. But let me explain.
The world wants U.S. dollars
In Fed Rate Hikes: Why Are Bond Yields Falling? Schwab Managing Director Kathy Jones explained that a strengthening dollar has driven foreign investors to U.S. stock and bond markets, causing U.S. interest rates to decrease rather than increase.
The yin and yang
But her article acknowledged that quantitative tightening could eventually result in interest rate increases as the Fed reduces its manipulation of bond prices, potentially raising 10-year interest rates back to the 3.5% reached at the end of June.
Interest rates can and will blow way past 3.5% on their way to a historic norm of inflation plus 3%, which is 12% in our current 9% inflationary environment. Quantitative tightening is the opposite of quantitative easing (QE) and is also called “tapering.”
QE is manipulation of bond prices with the intention of keeping interest rates low. Tapering is taking the Fed’s foot off of the interest rate brake. In addition to increasing short-term interest rates, the Fed has announced that it will also taper by allowing the bonds it holds to mature without replacement. And the Fed’s balance sheet has begun to decrease below its all-time $9 trillion high. It is in fact tapering.
Tapering will reduce stock and bond prices
Without the Fed’s intervention, bond prices will seek a fair market price. Foreign demand is buoying up those prices, mitigating the effects of tapering. But risk-reward pricing will eventually take hold. As shown in the following pyramid, bonds have historically yielded 3% above the rate of inflation.
Rising bond yields will impact stock markets in a couple of ways. Bonds will once again become attractive alternatives to stocks. Future stock earnings will be discounted at higher rates, reducing fair stock value.
Conclusion
My June prophecies have proven wrong, but it’s only been a couple of weeks. I remain convinced that it will be extremely hard to control inflation and that inflation will burst the bubbles in stock and bond markets.
The strengthening of the U.S. dollar is relative, and the result of being “the cleanest dirty shirt” in the laundry basket. The rest of the world is suffering the economic consequences of COVID and Russia too.
Our inflationary problems will not go away quickly. After all, we’ve printed more than $13 trillion in the past decade.
Ronald Surz is co-host of the Baby Boomer Investing Show and president of Target Date Solutions and Age Sage, Target Date Solutions serves institutional investors, namely 401(k) plans. Age Sage serves do-it-yourself individual investors.
His passion is helping his fellow baby boomers at this critical time in their lives when they are relying on their lifetime savings to support a retirement with dignity, so he wrote a book Baby Boomer Investing in the Perilous 2020s and he provides a financial educational curriculum.
Read more articles by Ron Surz
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Rising bond yields will impact stock markets in a couple of ways. Bonds will once again become attractive alternatives to stocks. Future stock earnings will be discounted at higher rates, reducing fair stock value.
