Assess market interest rates, yields and inflation

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What a quarter it was! The global bond market suffered its worst losses in decades. According to Bank of America Global Research, the sovereign bond areas of the United States and the former United States are on the verge of their worst years since 1949.

BofA Global Investment Strategy: Government Bond Returns

Global bond yields worst since 1949

Bank of America Investment Strategy, Bloomberg

Making yields much worse in credit is inflation. We all know that the headline CPI in the United States is growing at almost 8%, but the future paints a much better picture. Using Treasury yields and current TIPS rates, we can determine what the market thinks inflation will be. Over the next 12 months, inflation should come in at 5.1%. Delay it a few years, however, and the annualized increase in consumer prices should subside considerably. Five-year inflation expectations are 3.4% while, according to the St. Louis Federal Reserve database, 10-year inflation should be “only” 2.8% per year.

Measuring Expected Inflation Using Treasury Bills and TIPS

Strong implied inflation expectations

St. Louis Federal Reserve, US Treasury

Positive real returns in the bond market – You heard that right

What is shocking to most investors is that you can hold a low-cost, diversified bond fund today and beat inflation if market participants are right in their bets. The current yield to maturity (YTM) of the iShares US Aggregate Bond Market ETF (NYSEARCA:AGG) is just under 3% – above the expected 10-year inflation rate. It’s important to look at a bond fund’s YTM when trying to determine what your future performance might be.

Also, it is wise to ignore people who reject investments simply because of high inflation. How often do you hear, “Why own bonds?” You lock in a guaranteed loss after inflation! This is a very misguided argument since said speaker refers to historical inflation and historical bond yields. Any reasonable investor would certainly look to the future.

Review of performance at deadlines

Where else could you find a decent return? Areas of credit risk, such as emerging market debt, have a YTM of 6.4%, while domestic high yield (junk) bonds offer a rate of 6.0%. The YTM of high quality domestic credit is above its 10-year average, currently around 3.5% (easily above the inflation rate expected using comparable duration Treasury bills).

Stock returns

Some people like to observe the difference between bond yields and stock market dividend rates. Although I consider this an apples to oranges approach, it can be an indicator of relative valuations (known as the equity risk premium, at least when comparing Treasuries and the S&P 500 dividend yield). Currently, US growth stocks are a paltry return of 0.8%, while US value is just over 2%. The vast domestic stock market yields 1.5%, but go overseas and you’ll find higher dividends.

International equities pay relatively large cash flows to shareholders at 2.8%. The yield gap between US and ex-US markets is not far from historic highs. It may be a sign of value abroad.

JP Morgan: Asset Class Returns

Asset Class Returns

JP Morgan Market Guide Q2 2022

However, you don’t have to accept areas of credit-risk fixed income securities or volatile equities to earn a return. You can hold short-term Treasuries through ETFs (such as SHY and VGSH) and reap the potential benefits of an inverted yield curve. Short-term treasury bill rates are north of 2% and interest rate risk is low due to the short maturity.

An opportunity for your emergency fund?

The effective duration of a two-year treasury bill is, of course, about two years. This means that for every 1% rise in market rates, a short-term treasury fund may only lose 1-3% of its net asset value. If rates stay the same, you can just grab an interest rate of 2-2.5% (which beats the pants of high-yield online savings accounts right now).

Conclusion

My take: First quarter returns were weak in global equity and bond markets. But it creates both short-term and long-term opportunities. If we are indeed at the peak of inflation this month and next month, real bond market yields should improve while dividend yields, after inflation, should also start to turn respectable.

Investors should consider the safety of fixed income securities at this time, even with its volatility. Bond funds, although down over the year, offer much more attractive returns after a tumultuous Q1.

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