Mortgage rates have risen above 3%. The 10-year treasury has spiked above 1.5%. How can all this happen when the Fed is keeping rates at zero?
The answer is that the Fed doesn’t control the long end of the yield curve. By setting the Fed funds rate, the U.S. Central Bank establishes the base price of money: in effect, the wholesale price of money from which all other interest rates are derived. By doing so, they influence yields across the entire yield curve, including intermediate and long-term bonds. But they have no direct control over yields that are further out on the curve: these are in the grips of bond traders, whose daily market trades determine both prices and yields.
In recent weeks, bond traders have worried that the Fed is losing control of nascent inflation. The massive stimulus—both monetary and fiscal—of the past pandemic year has produced an unparalleled money-printing operation. It’s right to worry about inflation at this juncture. Inflation is the genie that cannot be stuffed back in the bottle. As economists often say, inflation is like a bottle of ketchup. You shake it over your fries again and again and it doesn’t come out. Then you hold it up to your eye so you can see where it’s blocked and it immediately explodes in your face.
The DAX Index yield curve
It’s been a long, long time since we really had to worry about inflation. The double-digit years of rising prices during the ‘70s are a memory of another generation. Weimar wheelbarrows full of marks in 1920s Germany are only historical artifacts online, with little resonance for modern investors. The hyperinflation of emerging markets has always left the U.S. unscathed. But inflation is a force to reckon with, and the Fed knows it ignores it at its own peril.
Hence, the fear of bond traders and the rise in rates—as traders watch for signs the Fed will be raising the Fed funds rate to counter inflation.
The prices of existing bonds sink when prevailing rates rise. This has always been the rub in the idea that bonds are “safe.” Bonds are considered protected because they’re contractual promises of repayment. For centuries, bonds have been deemed suitable for widows and orphans because, so long as they don’t default, they pay their interest and principal. Treasury bonds are considered so secure that their yields are used to calculate the “risk-free” rate in stock models.
This belies the problem with so-called safe bonds—that they are anything but when interest rates rise. The reason why bond prices sink when prevailing bond yields rise is that old bonds lose their appeal once their younger cousins sport a more attractive yield.
Picture, for example, that you own a 10-year Treasury bond with a face value of $100,000 and a yield of 2%. As a lender to the U.S. Government you receive $2,000/year in interest for your troubles. But if bond yields rise to 4%, now you have a problem. If you want to sell your bond to buy a house, you will have to accept a lower price than you paid. This is because new bonds are paying twice as much as yours and so no one really wants your old, tired piece of paper that produces only 2%. You will have to discount your bond to a price that puts the buyer in the same position as a buyer of a newly issued bond. The result is a shocking loss on your $100,000. If ten years remain on your bond, you won’t be able to sell it for more than $84,000—a loss of 16%.
Long-term bonds are more prone to this interest-rate risk than short-term ones, because the money is by definition tied up for longer. Some people practice self-delusion by telling themselves that if they hold the bond to maturity they’ve lost nothing. This ignores the opportunity cost they’ve incurred by owning a low-interest-rate bond in a high-interest-rate, rising inflation environment. So when someone tells you long-term bonds are safe, remember that safety is in the eye of beholder. And the holder and beholder of a 10-year Treasury bond at current rates holds nothing safe at all.
James Berman runs a global equities fund that invests in the United States, Europe and Asia. As the president and founder of JBGlobal.com LLC, a registered investment