Inflation, Bonds and Interest Rates
Monthly AIRE Perspectives – April 2022
Dear Friends and Valued Clients,
Please see below for The MAP – Monthly AIRE Perspectives for this month. Please make sure to review this each month!
NEW! By the Numbers
Attached to this email is a copy of By the Numbers (BTN), a weekly email publication that AIRE Advisors has subscribed to on behalf of our clients. We think you'll find it quite beneficial as a source of quick facts and data from the investment world that are great pieces of information for investors. We will post this weekly on our LinkedIn page and our upcoming Facebook page, and periodically share one or two bullet points in more detail on The MAP each month. Please connect with us on LinkedIn by clicking here. We will send out our upcoming Facebook and additional social media pages once they have been activated, which will be later this month.
Note that BTN is a copyrighted publication and that you are receiving it because of our business relationship. The email is for your entertainment and benefit and is not to be forwarded onto other individuals. Enjoy!
Focus: Inflation, Bonds and Interest Rates
From the attached “By the Numbers”, we would like to highlight items 3 and 4, relating to inflation:
It is clear that we have experienced unusual inflation during the past year. There are many reasons that have been cited for why this has occurred, including an increase in money supply, rising oil prices as a result of the Russian invasion of Ukraine, supply chain issues and more. While it is difficult to predict if and when inflation will subside to lower levels (many economists are currently predicting 1-2 years), our discussion here is not to speculate on future inflation levels, but to discuss interest rates and the impact of inflation on bond prices.
Let’s begin with the Fed, which raised the Federal Funds Rate in March from a target of 0-0.25% to 0.25-0.50%. Given the current situation, we have often heard people ask us what we should do with bonds, given that rates are going to increase. This, however, is an incorrect assumption, and warrants a brief explanation and understanding of how bond markets work. The Federal Open Market Committee (FOMC) sets the Fed Funds rate, which is the rate at which the Fed suggests for banks to lend money to each other as needed on an overnight basis. This is an overnight rate, and one that is set by the FOMC rather than directly by markets. In the investing world, when we talk about interest rates, we are generally referring to bond market interest rates, which are not set by the Fed or any particular entity, but by supply and demand.
The demand for bonds can be impacted by many factors, including inflation, the Fed’s indications about future Fed Funds rate moves, and much more. But, similar to the stock market, where current conditions and future predictions are priced in instantly, bond market interest rates change in anticipation of future “predictions.” Over the long run, bond rates tend to move up and down with inflation. If we have sustained high inflation for many years, we might see bond rates continue upward. However, our experience has shown that the bond market tends to be very efficient, and prices in future inflation predictions. When we talk about bond market interest rates, we are generally speaking about benchmark rates, which are the current interest rates on the 5-year, 10-year and 30-year treasury bonds (in addition to other maturities). Short-term bond rates (less than one year) tend to move almost immediately with the Fed Funds rate. Longer-term rates, however, such as the benchmarks mentioned here, act in anticipation of where the market thinks things are headed.
That is not to say that the bond market is always right, as those rates do continue to change with new information, but it is to say that future interest rates become impossible to predict, as bond rates move in advance of expected future moves in inflation and the Fed Funds rate. To illustrate this, let’s show you the specifics: here are the trailing 12-month low interest rates on the 5-year, 10-year and 30-year treasury interest rates compared to their rates today:
| Bond | Trailing 12-Month Low Rate | Today's Rate (4/20/2022 |
|---|---|---|
| 5-year Treasury | 0.61% | 2.87% |
| 10-year Treasury | 1.13% | 2.88% |
| 30-year Treasury | 1.68% | 2.95% |
BondTrailing 12-Month Low RateToday's Rate (4/20/20225-year Treasury0.61%2.87%10-year Treasury1.13%2.88%30-year Treasury1.68%2.95%
As you can see, when it comes to bonds, interest rates have already gone up substantially, to reflect inflation, as well as the market’s consensus predictions about the future of inflation. The 5-year treasury, in particular, has had an almost 5-fold increase in its rate during the past 12 months. This is why it is impossible to predict future movements in interest rates: the bond market prices in new information immediately. In fact, there is a study we often quote that shows a Wall Street Journal survey of economists, conducted every 6 months for the past 40 years, which asks a simple question: are interest rates on the 10-year treasury going to go up or down in the next 6 months? The predictions were correct only about one third of the time on a 50-50 guess. So the lesson here is: do not try to predict interest rates, because the market has already done that for us.
So, what is the answer when it comes to fixed income investing? We believe that the answer lies in the foundation of our message: it is about portfolio construction. Longer-term bonds perform better if rates stay the same or go down, as you tend to lock in a higher rate, while short-term bonds perform better if rates go up, as you get your principal back and can then re-invest at a higher rate. Given that there is no reliable way to predict interest rates, some strategies that could be more appropriate include:
Laddering – buying bonds at different maturities, based upon your particular goals and time horizon.
Diversification – by maturity date, issuer types, premium versus discount bonds, and more.
Periodic Purchasing – buying at different points in time to diversify your entry dates. For example, we have bought some high quality intermediate term municipal bonds recently at rates above 4% tax-free. These rates have gone up from about 2.5% just a few months ago. So we take advantage of the increase, but leave additional funds in short-term paper in case rates go higher in the future.
The ultimate message here is that the best practices in bond investing are similar to the best practices in stock investing, in that the main concern should be each person’s financial goals, time horizon and risk tolerance, rather than a prediction on the future direction of interest rates. We will be presenting a more comprehensive webinar on fixed income markets in the near future, and will keep you posted. If you have further questions on this, please feel free to contact us at any time.
Wisdom from Warren Buffett
To support some of what we discuss above (and regularly), we thought we would share a great CNBC article sent to us by a valued client and friend, titled: Warren Buffett Guide to Investing. We encourage you to click on the aforementioned title to read the entire article, but here are some quotes (along with CNBC commentary) we thought were worth highlighting:
On stock picking:
“They (advisors) come in and they talk for hours, and you pay them a large fee, and they always suggest something other than just sitting on your rear end and participating in American business without cost.” — 2016 BERKSHIRE ANNUAL MEETING
To prove his point, in 2007, he made a massive 10-year bet for charity with a proponent of active investing that a low-cost Vanguard S&P 500 index fund would outperform a hand-picked basket of hedge funds, which charge large fees. At the end of the wager, the S&P index fund had gained 125.8%. The hedge funds were up an average of around 36%.
On market timing:
Charlie (Munger, Buffett’s longtime business partner) and I haven’t the faintest idea where the stock market is going to go next week, next month, or next year. We never talk about it…
“We don’t have an opinion about where the stock market’s going to go tomorrow or next week or next month. So, to sit around and not do something that’s sensible because you think there will be something even more attractive, that’s just not our approach to it…Picking bottoms, I think, is probably impossible.”— 2009 BERKSHIRE ANNUAL MEETING
On market drops:
“My enthusiasm for stocks is in direct proportion to how far they go down. I like it when things I like go down in price…Am I better off if I have to pay high prices or low prices? So, it’s not bad news for us when stocks go down at all. Now, you know, it’s bad news for us when something goes wrong with a company. But the fact that something gets cheaper, I mean, if I walked into McDonald’s tomorrow and they’ve cut the prices of hamburgers by half, you know, I will be happy because I’m going to be buying hamburgers for a long time.” — CNBC SQUAWK BOX INTERVIEW, MARCH 1, 2010
On behavioral finance and the importance of emotional discipline:
“If you have a temperament that when others are fearful you’re going to get scared yourself, you know, you are not going to make a lot of money in securities over time, in all probability. You know, people really — if they didn’t look at quotations — but, of course, the whole world is urging them to look at quotations, and more than that, do something based on small changes in quotations… Think how much more rational investing in a farm is than the way many people buy stocks. If you buy a farm, do you get a quote next week, do you get a quote next month? If you buy an apartment house, do you get a quote next week or month? No, you look at the apartment house or the farm and you say, I expect it to produce so many bushels of soybeans and corn, and if it does that, it meets my expectations… Some people really do not have the — apparently, they don’t have the temperament, or emotional stability, or whatever it may be, to invest in securities… In the end, what counts is buying a good business at a decent price, and then forgetting about it for a long, long, long time. And some people can do it and some people can’t.” — 2010 BERKSHIRE ANNUAL MEETING
On the fear of missing out (“FOMO”) and being envious of people making money from risky behavior:
“People win lotteries every day, but there’s no reason to have that effect you at all. You shouldn’t be jealous about it. If they want to do mathematically unsound things, and one of them occasionally gets lucky, and they put the one person on television, and the million that contributed to the winnings, with the big slice taken out for the state don’t get on — it’s nothing to worry about. All you have to do is figure out what makes sense… Let the rest of the world go its own way. You don’t want to get into a stupid game just because it’s available.” — 2016 BERKSHIRE ANNUAL MEETING
Once again, we would like to thank you for your trust and loyalty, and look forward to speaking with you in the upcoming month.
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