Bonds are in a pickle!

Inflation in the US is near 8% and bond ylds at 2.5% which means you are losing 5.5%. or real rates are negative. This seems very odd, and one would assume that A) bond prices would need to drop to at least breakeven i.e. to an 8% yld or B) bond holders expect inflation to tumble in the near term. What other answer can there be? Maybe a combination of factors, that inflation will fall, that 2.5% is better than nothing i.e. alternatives are worse and /or human behavior where investors are in denial and every day slowly take losses on bonds. The US bond market is very large and dominated by institutional investors that include most sovereign nations including China and Japan with US$2 trillion in treasury holdings.   

The key to the dilemma is inflation, what part is due to the pandemic, stopping the world and starting again created a supply shock while many governments implemented massive stimulus programs and drove demand. Then came the mystery of the missing workers and wage inflation, plus structurally low investment in key metal and energy sectors that limited capacity increases and then the Russia invasion of Ukraine. One disaster feed into another and prices for everything increased.  

This is not a classic example of inflation when the value of money falls due to central bank printing or due to incredible demand on very easy money, it’s a combination of drivers that makes this situation unique that, in my view, make classic explanations and remedies less applicable.

The main question is if inflation gets anchored, set into consumer and company behavior, a new normal. When that happens, inflation becomes endemic and difficult to stamp out.

Assuming inflation does not get anchored, high prices lead to lower demand, higher interest rates also send the signal to consumers and business that it’s time to reduce spending and investment. Demand falls and so do prices but at a cost to general welfare. One risk, that leads to stagnation and inflation (stagflation) is lower investment, supply falls faster than demand and this keeps inflation or prices higher for longer. It’s a difficult balancing act that few central banks can maneuver since it a free economy, companies and consumers are free to choose.  

My view is that inflation will take some time to normalize, and Bonds should continue to fall as the Fed and Central Banks around the world use classic monetary policy to address the supply and demand equation.  Think about shorting bond ETFs or better yet look at inverse bond ETFs. See list below

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