Many cries, one wolf

Ten years ago, the financial press worried about the price of US Treasury bonds. “Time for a bond market crash?,” asked Business Insider. Marketwatch advised “what to do before the bond bubble bursts.” In The Wall Street Journal, The Wharton School’s Jeremy Siegel addressed “the bond bubble and the case for stocks.”

The professor’s faith in equities was well-placed. Since Siegel wrote those words, the Morningstar US Market Index has appreciated by 350%. However, his fears about bonds, along with others’, was misplaced. Across all maturities, Treasury yields today are lower than they were in 2011. In addition, total returns for intermediate- and long-term Treasuries have exceeded the inflation rate.

Forecasting bear markets is much like quitting smoking - so easy that one can do it repeatedly. Through the past 30 years, stock-market skeptics have correctly forecast just one downturn: that of 2000-02. Otherwise, the prophets of doom have consistently been wrong. For example, on Dec. 4, 1996, when Federal Reserve Chairman Alan Greenspan wondered whether stock prices were exhibiting “irrational exuberance,” the S&P 500 was priced at 745. It closed the following year at 875 and never finished any subsequent year below 950.

(Stocks did crash on two other occasions, during the 2008 global financial crisis and then against last spring. But neither of those declines were widely predicted. Entering 2008, the era’s most widely respected stock-market strategist, Abby Joseph Cohen of Goldman Sachs, thought that US equities would “finish in the plus column for the year.” Siegel was more bullish yet. As portrayed in “The Big Short,” the dissenters were few and mostly obscure. And of course, last year’s plummet came as an almost complete surprise, courtesy of the novel coronavirus.)

Nothing but success

At least the stock market’s doubters were correct once. The bond market’s critics haven’t been right since Ronald Reagan held office; effectively, Treasury yields have done nothing but decline. Along the way, pessimists have periodically questioned the bond market’s sanity, including Alan Greenspan, who in April 2017 repeated his “irrational exuberance” charge, this time about bonds. Wrong again.

This time might be different. As the preceding paragraphs have acknowledged, those are dangerous words. However, it’s worth noting that since 2011, when bonds were loudly proclaimed to be overpriced, conditions for bond investors have steadily eroded. By all measures, bonds are costlier today than they were 10 years ago.

More money

In recent decades, the connection between money supply and inflation has greatly weakened. Whereas Milton Friedman’s statement--“Inflation is always and everywhere a monetary phenomenon that … can be produced only by a more rapid increase in the quantity of money than in output”--was once regarded as a truism, economists now wonder why money creation in developed countries has outstripped output without sparking inflation.

Nevertheless, although the traditional measures of money supply have lost much of their predictive powers, there’s no doubt that Friedman’s precept remains valid as a general principle. Eventually, more money must lead to higher prices. The relevant question is not if money creation will increase prices, but when.

That answer will come when it comes; economists can only guess. However, there’s no doubt that the day money supply ignites significant inflation is closer now than it was in 2011. Meanwhile, money is being created ever more rapidly. In the 10 years from November 2001 through October 2011, the M2 money supply increased by 78%. Over the next decade, M2 grew by 120%.

Higher inflation

As has been widely noted, US inflation has surged recently. Policymakers believe this increase to be temporary, caused by imbalances as the economy emerges from recession. In a recent speech, Federal Reserve Vice Chair Richard Clarida summarised this view, stating that US core inflation will be “at least 3.7% this year before reverting back to 2.3% in 2022, 2.2% in 2023, and 2.1% in 2024.” Consequently, the central bank is maintaining a near-zero federal-funds rate.

The Federal Reserve’s argument may be correct. (Those who hold long bonds must fervently hope so--because if inflation does not soon subside, Treasury prices will plummet.) Still, the current inflation news is clearly worse than that of 10 years ago. In November 2011, the annualised three-year growth in the Consumer Price Index was 1.5%. Today, that figure is twice that level, at 3.0%.

Lower yields

Presumably, higher money growth and steeper inflation should produce steeper Treasury yields. Not so. Ten years ago, 30-year Treasuries paid 3%, with 10-year notes yielding 2%. The comparable rates today are 1.87% and 1.53%, respectively. The possibility of meaningful inflation now appears greater than in late 2011, yet Treasury yields are much reduced, as is the margin of safety for bond investors.

Indeed, even as headline inflation has spiked during this past month, Treasury bonds have rallied. The 30-year Treasury entered November yielding 1.93%. Barring a three-hour retreat (I write these words at 2:00p.m. Eastern time on the final day of the month), that bond will finish the month costing more than when it began.

The prudent course

That Wall Street disagrees with Main Street is neither new nor a cause for investment concern. Just because most Americans now view inflation as a major problem, while Treasury prices suggest otherwise, doesn’t indicate that bond investors have erred. Just as prognosticators have frequently foreseen ills that never materialized, so too does the public. For example, while stocks have soared during the past 18 months, consumer confidence has trailed its 25-year average.

Still, the dangers of long bonds would appear to outweigh their benefits. In exchange for receiving 1.5 more percentage points of annual yield than they would obtain from cash, along with the possibility of strong performance should another recession arrive, Treasury investors court the ever-increasing risk that the skeptics will finally be right, leading to double-digit capital losses. That doesn’t seem like a sound bet to me. Better instead to hold short notes and/or cash.