It’s almost as if I can see the future.
In the September 22 issue of The 10th Man, I went through the math of how people would get screwed in a bond bear market.
I gave some concrete examples of what would happen if rates backed up 100 basis points. And sure enough, since the election, rates have backed up about 40 basis points.
Chilton Capital's REIT Composite was up 6.1% last month, compared to the MSCI U.S. REIT Index, which gained 4.4%. Year to date, Chilton is up 6.3% net and 6.5% gross, compared to the index's 8.8% return. The firm met virtually with almost 40 real estate investment trusts last month and released the highlights of those Read More
This has meant heavy losses in bonds and bond funds.
Like our friend TLT here:
I will say with certainty: the bond bear market has begun. I will stake my reputation on it.
I’m not the only one saying it. Ray Dalio said it also, on LinkedIn. Ray Dalio, of course, runs the largest hedge fund in the world: Bridgewater, with well over $100 billion in assets.
Get ready for multiple rate hikes by the Fed
What Ray Dalio and Bridgewater do better than anyone else is study economic history. And Mr. Dalio says that our very swift and sudden regime change signals a prolonged period of higher inflation and higher interest rates.
Donald Trump has stated quite clearly—many times—that he wants to lower taxes and spend money… on just about everything. We will be running much larger deficits, which means more bond issuance at auctions.
What we are now seeing is the bond market responding to the threat of increased supply (and inflation).
If you don’t know how a bond auction works, I suggest you read up on it. When you understand how auctions work, you will understand intuitively the supply/demand dynamic that leads to higher interest rates.
Meanwhile, inflation expectations are ramping, looking at the 5y5y forward breakevens (the market’s estimate of 5-year inflation expectations, 5 years forward, as implied by TIPS prices):
Which the Fed is watching for sure.
And right on cue, the second-most dovish member of the Board of Governors, Daniel Tarullo, is in favor of hiking interest rates sooner rather than later.
The timing on that particular change of heart has to be the most spectacular coincidence in the world (I’m being sarcastic).
A December rate hike is a given, but what the market doesn’t yet realize is that there will be multiple rate hikes in 2017.
As in, more than one. Possibly many.
Consequences of a bond bear market
If this is the beginning of a bond bear market—and I think it is—there will be consequences.
- Retail investors in bond funds will get annihilated. Actually, one of the main reasons for holding a diversified portfolio of bonds and stocks is that there are benefits to diversification. But when both asset classes become correlated with each other—as they have been—the diversification benefits disappear.
- As the Fed raises interest rates, the certainty equivalent looks better and better. You can earn more than 1% in some enhanced cash funds right now.
- As inflation rises, which it inevitably will, real returns of fixed income securities will be eroded.
- This is probably the top of the housing market for a while.
- Auto sales, which are declining, will decline more.
- Non-dividend-paying stocks with the longest duration, like tech and biotech, will suffer. (Biotech is probably fine if Trump relaxes regulations on healthcare.)
I’m going to stop there, but the implications go on and on.
Literally the whole world has exposure to higher rates. Sometimes it is easy to see where it lives (retail investors, today) and sometimes not (like Procter & Gamble in 1994). We are just scratching the surface here.
Remember what we said in Bond Math Class: when interest rates go up, stuff blows upTM.
In a few weeks, you’ll probably be reading articles in the Wall Street Journal about retail investors freaking out about the losses they’ve sustained in their bond funds, totally stumped about the relationship between bond prices and interest rates.
I’ve done my part. I’ve written quite a few times in the past about the bond bubble, and I devoted an entire 10th Man issue to the mathematics of bond prices.
I’m sure there are some people reading this, thinking: “Crap, am I too late?”
That is a particularly deadly psychological condition. You don’t need to sell the top tick. Anything close is fine. And this still qualifies as “close.”
But I’m sure some people will experience paralysis and won’t sell, and then they’ll watch helplessly as interest rates rise to 3% and higher, then sell their bonds on the lows.
This has been a very serious piece. I’m a serious guy, at least when it comes to stuff like this.
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