Bond Markets Are Telling Us Something

Rodney Johnson |

I think the idea that cars, sports equipment, etc., can “talk” is a guy thing. I can’t recall seeing a woman talk to a golf ball before she teed off, and yet I know plenty of guys who do this, even before they start drinking!

Guys will ever so calmly (said sarcastically) discuss life with their car if it refuses to start. Even in that statement I used “refused,” as if the car was making a choice not to start.

When it comes to the markets, we talk about them making fools of everyone, or not giving anyone a clear indication of what is coming next.

That’s all nonsense of course, except when it comes to the bond markets. In this instance, I’m sure there’s something to the notion of a talking market, and recently the bond market has not been whispering quietly, it’s been screaming.

Over a month has passed since the Federal Reserve technically exited the bond markets. I say “technically” because the central bank has pledged to keep its balance sheet at its current size, which means as bonds mature, they will buy more to replace them.

That being said, the latest quantitative easing program was shut down in late October. Since then, interest rates haven’t shot to the moon, even though the U.S. bond markets lost a huge player that routinely purchased billions of dollars’ worth of inventory every month. In fact, interest rates have fallen while prices have moved higher.

Some people might count this as a victory, noting that the bond markets can survive and even thrive without the Fed. I think those people aren’t listening to what the market has to say.

The interest rate paid on bonds compensates investors for several things — the use of their money, the loss of value because of inflation, and the risk investors take by lending money in the first place.

U.S. Treasury bonds and others backed by the U.S. government, which are the kind that the Fed was buying, are considered risk-free, so they only compensate investors for the use of their money, called the real rate of return and the expected loss due to inflation or the inflation rate.

No one knows what the real rate of return is. It’s not published in a book or calculated using specific inputs. In general, it’s computed by simply subtracting the long-term expected inflation rate from the current interest rate paid on a bond. What’s left is the real rate of return.

Over many years the real rate of return was near 3%, but not any longer.

This is where the bond market is trying to tell us something.

Currently, the one-year U.S. Treasury bond yields 0.18%. Inflation is roughly 1.7%. Subtracting the inflation rate from the yield (0.18% to 1.7%) gives me a real return of -1.52%. So investors are buying a security that they know will net them a loss of 1.52%.

Hmm.

Longer bonds don’t fare much better. The yield on a five-year U.S. Treasury bond is about equal to the current rate of inflation (1.67%), so buyers of these bonds will break even 60 months from now.

The 10-year U.S. Treasury bond has a yield of 2.10% and after subtracting the inflation rate of 1.7%, it results in a 0.40% real rate of return. The only good thing that can be said about this rate is that it’s not negative!

Even the 30-year U.S. Treasury bond pays a paltry rate of interest of 2.71%, which equates to a real return of 1.01%.

I don’t think bond buyers are blind to these numbers.

I think they’ve assessed the investment and economic landscape, and see little opportunities for growth in the years to come as well as modest inflation at best. In essence, bond buyers are willing to invest for almost no return, as long as they have a strong belief that they will at least get their money back.

How else do you explain investors signing up for a loss on bonds shorter than five years, and accepting a measly 0.40% rate of return on 10-year U.S. Treasury bonds?

The bonds markets are screaming at us. All indications point to a period of low growth and modest, if any, inflation.

The most important factor today when buying bonds isn’t the return on your money; it’s simply the return of your money.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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