Yesterday’s pseudo-capitulation by the Fed chief during a speech was interpreted by the market as a sign that the Fed is very close to ending its rate increasing campaign. More experts are tilting towards the possibility of recession next year. If recession comes then yields will drop, in which case investors who own money market funds would miss out on the chance to lock in intermediate term yields. When yields drop deeply then bond issuers refinance (they “call” the bond in) and investors are then forced to reinvest at lower yields. An exception to that is that Treasuries have lifetime restrictions and Munis usually have 10 year restrictions on calling in outstanding debt.
Assuming that the paradigm that recessions come every 5 to 9 years is correct then we are overdue for one. The failure of overconfident, “top of the cycle” junk bond issuers may be the key element of a tipping point that tips over a cycle into recession (remember subprime loans in 2007, or corporate junk bonds in 1989?). Since the recovery from the 2008 crash there has been plenty of junk quality debt issued in the form of CLO’s, CDO’s, Bank Loan Funds, peer-to-peer lending, Business Development Companies, junk bonds, etc. It seems likely that soon these junk quality credit will fail and tip the economy over into a recession. When junk credit fails then new junk applicants get cut off from funding as lenders panic and lock down their risk. This is the tipping point that triggers recessions, although it is accompanied by Fed rate increases that also hurt investment grade borrowers. The shock of loss of credit to those “B” paper types who need it most can result in a sudden closure of a business and loss of jobs; this is more dramatic than an “A” paper consumer being told because rates went up that he’ll have to pay an extra $30 a month for a debt-financed purchase.
Looking at downside risk, if rates rise for short term and intermediate term bonds it may be possible over several years that rising rates can boost the total return due to coupon reinvestment at higher rates, even though rising rates make bond prices go down. The key is to keep duration under 5.
Compare the risk of rising rates, making bond prices go down, with the risk of missing out on earning yield if rates go down and Money Market fund yields plummet to zero. I think the risk of a Japan-style steep drop in yields during the next recession far outweighs the risk of rising rates damaging a bond portfolio, but just in case, limit your bond portfolio duration risk to 5.
The best bond asset class are long term Munis so that is the place to take on a moderate amount of portfolio duration risk. Mortgages have convexity risk where, if rates rise, that increases duration, and if rates fall then portfolio yield is reduced as refimania makes the mortgages get refinanced, thus requiring purchasing new, lower yielding bonds.
Today the PCE core inflation index was released showing a 3 month annualized change of 1.15%, which is almost half the rate of a half year ago. So inflation is slowing down, even though unemployment, at 3.7%, is at record lows. This is very unusual to have a low rate of unemployment which usually correlates to a high and rising rate of inflation. It is because the true quality of the employment market is very poor for those not highly skilled and thus many unskilled people are nominally employed at pseudo-jobs that can’t possibly be used to create inflation.
GDP and PCE (especially if adjusted for a problem measuring rent) are the best measures of the risk of inflation, since employment data doesn’t measure employment by quality of the paycheck. The dominant theme of corporations is to cut costs by shipping jobs from Developed countries to EM countries, meanwhile the EM world is full of government sponsored make-work projects that are unsound, creating a global oversupply that pushes down inflation. These two forces of Dev country corporations and EM governments pushing export industries are jointly creating a massive disinflationary force the world has never seen before. Thus old paradigm that the 10 year Treasury should have a real yield of 2.08% (roughly 1% higher than now) are no longer applicable.
What if every person lost his job and immediately replaced it with a minimum wage or speculative grade commissioned sales job. Then people would need to urge unemployed spouses to rejoin the labor force, further pushing down unemployment. Yet if more people were employed, but at a lower aggregate income, then society would be less capable of generating inflation.
For inflation (like that of 1965-1982) to come back it would require that globalist corporations suffer some kind of defeat in economic battle (confiscation, harassment, strikes, etc.) where they get chased out of low wage EM countries and decide it is worth paying up for Developed country wages. This hasn’t happened and it would be dumb for EM countries to let it happen. There is no sign of labor unions (except for some big city government employee unions) succeeding in Developed countries, to replicate the high wage environment of the 1945-1982 era.
This is not a time to go to ultra-short duration bonds, rather it is time to have a 5 year duration investment grade portfolio and to avoid junk quality credit.
Bond investors need independent financial advice about the risks of misunderstanding inflation.