Rising rates on “risk free” assets have turned a frantic search for yield into an even more frantic dash for a shrinking exit. Conventional wisdom today is that interest rates are moving higher and investors are voting with their feet, running away from risk interest-sensitive sectors of the market. But the consensus track record is spotty at best and following the herd has historically been an expensive habit, albeit one that is psychologically difficult to break.
The Bond Bogeyman
For years, we have argued that interest rates are likely to stay lower for longer than most market participants were able to envision, given the powerful deflationary forces created by balance sheet deleveraging in the aftermath of crisis. With private sector balance sheets in much better shape today and unconventional monetary policy quickly becoming conventional, we are approaching the conclusion of this extended deleveraging process. As a result, interest rates should naturally move higher over time as domestic growth improves and economic imbalances continue to adjust. But this process remains far from complete.
Short term fluctuations in the bond market may be driven by a number of factors but long term levels of interest are ultimately a function of inflation. When viewed in this perspective, the outlook for treasury yields looks quite favorable, as the inflation bogeyman has yet to come out of the bottle and inflation expectations continue to fall despite the rise in nominal rates. According to the good folks at Hoisington Investment Management, the Treasury bond yield and the inflation rate have moved in the same direction 80% of the time since 1954. Accordingly, this year’s performance is quite unusual, considering that one of the Fed’s favorite inflation indicators (the core personal consumption expenditures deflator) stands at a record low for the entire five plus decades of its history.
Over the past year, interest rates have risen as nominal growth has continued to slow. In fact, GDP growth is the slowest of any expansion on record since 1948 and below the level that marked the entry point of every economic contraction over this period. Despite consensus hopes that the economic “recovery” will soon accelerate (such dreams typically begin in “the back half” of each year), the data clearly demonstrate chronic long term economic underperformance.