And bonds are not the place to be these days. Can you believe that the income recently available from a 10-year U.S. Treasury bond – the yield was 0.93% at yearend – had fallen 94% from the 15.8% yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt. Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.
― Warren Buffett from his 2021 Annual Shareholder Letter.
BONDHOLDERS ARE LOSING MONEY
The stock market started the day relatively flat, but investors’ mood turned sour around mid-day following comments from Federal Reserve Chairman Jerome Powell. Powell confirmed that the central bank’s quantitative easing (QE) policies will stay in place until the labor market improves, stating that the Fed will remain “patient” even if inflation rises. The 10-year Treasury soared on the news, which, in turn, rattled the markets. The S&P 500, Dow and NASDAQ slipped more than -1.3% lower, while the 10-year Treasury interest rate rallied back to about 1.6%.
While the Fed changed this policy a few months ago, it was a monumental change in what economists call the Fed’s “reaction function” which is the measures and thresholds that cause the Fed to change monetary policy or interest rates. For the past couple of decades, the Fed would raise interest rates if inflation went to 2%. Now, Chairman Powell says he will not put the brakes on monetary policy unless we recover full employment, regardless of inflation above 2% for a while.
The reality though is there is inflation now, and the Fed is no longer in sync with the market for the moment. The U.S. dollar is weak, and a weak dollar creates commodity inflation since commodities are priced in U.S. dollars. And given the massive deficit that the U.S. is running, which is expected to account for 10.6% of total GDP, it is unlikely the U.S. dollar will strengthen any time soon.
The irony here is that growth stocks, which were also hit hard today, and the last three weeks. But they are not interest-rate sensitive. Their long-term drivers are sales and earnings growth. Some are saying that the higher interest rates reduce today’s value of growth companies’ future earnings, and that is true. But the market is also ignoring the estimates of nominal economic of +10% for this year. That growth will surely expand this year’s and future years profits.
It is important to keep in mind that the fourth-quarter earnings season is almost over, so it is also time for the market to “burp” and digest its recent gains. Remember, just a few weeks ago, the S&P 500, Dow and NASDAQ were all sitting at new all-time highs.
I expect the stock market to trade relatively sideways in the first half of March, as the stock market consolidates its earnings season gains. But after that, quarter-end window dressing will begin, as professional money managers shore up their portfolios by scooping up shares of fundamentally superior stocks like the ones we own.
In addition, our stocks should also benefit from positive analyst revisions in late March and early April ahead of the first-quarter earnings announcement season. Analysts have already aggressively increased estimates over the past two months, so the first-quarter earnings season should be stunning and possibly even more spectacular than the fourth quarter.
Many eulogies have been written for the “bond vigilantes” that were once said to prowl global markets for spendthrift countries to bully into fiscal rectitude. But the vigilantes seem to have saddled up again. The term was originally coined by former EF Hutton economist Edward Yardeni in the early 1980s to describe how bond selloffs could force the hand of central banks or governments.
BONDHOLDERS HAVE A BLEAK FUTURE
Including today’s rise in interest rates, the iShares 20 Plus Year Treasury Bond Exchange Traded Fund (TLT) is down -12.4% over the last 50-day trading period. That ranks as one of the sharpest declines over a 50-trading day period since the bond fund’s introduction in 2003.
Before last week, the last time the ETF was down by as much over a 50-trading day period was in December 2016 just after the election. The recent sharp downside move in long-term US treasuries has been a big wake-up call for investors, but at the same time, it has hardly been unprecedented.
First, the bond market has seen these big moves recently. This is now the third-worst YTD drawdown in the last thirty years on the Merrill Lynch 10+ bond index. And outside of professionals, it’s not much of an event. It is however because the risk of higher rates persists, and this could end up being the worst year ever in the bond market. It matters because the sheer size of the treasury and all credit markets in the US have exponentially grown over the last ten years. This is the biggest risk right now.
The markets have been in one of the most speculative periods in recent memory. Stocks globally have gone up with many indexes hitting all-time highs. Participation is very high with the average person now talking stocks or cryptocurrencies not as investments but as vehicles to get rich fast. Charlie Munger, Warren Buffett’s right-hand man, was interviewed this week by Julia Laroche and his comments were sharp at 97 years old.
This breather at the end of a spectacular earnings season is healthy. Some of the excess speculation needed to be released.
It is a great time for stocks, and a dangerous time for bonds and “income plays”. Bonds are the most dangerous investment right now.