There is a real buzz in the air about inflation. With the recent spike in long-term interest rates, the fear of runaway inflation has become the proximate cause of every zig and zag in the markets. Is all the talk worthy of serious concern?
Congress will send its next Covid-relief package to the White House for the president’s signature in the days ahead. This latest fiscal package will add trillions more to an already-projected $2.3 trillion federal budget deficit in 2021. This is on the heels of last year’s $3.1 trillion deficit. Understandably, this has reinforced the idea that we’re dealing in funny money.
This feeling is especially palpable given that the Federal Reserve has also joined in the effort to juice a post-Covid economic recovery. Over the past year, the Fed has created $3.2 trillion out of thin air and has purchased government-backed bonds with it. It’s no wonder Bitcoin has entered the mainstream investment lexicon!
With the game-changing vaccination campaign underway, some now believe we’re adding unnecessary fuel to a smoldering economic fire. More specifically, the concern is the raging fire and the coming rebound in demand for goods and services will outstrip our economy’s ability to meet it. This could be aptly described as a classic recipe for inflation.
However, since its low was reached last August, it’s important to note that longer-term interest rates have really only been creeping up. The highly-watched 10-year US Treasury rate has only clawed its way back to 1.5%. Yes, the move has accelerated lately. But, it’s really been a semi-orderly move, all in all.
In fact, over much of the past decade the yield on the 10-year Treasury has routinely traded between 1.5% and 3%. Returning back to 1.5% after the complete Covid collapse is not too extraordinary to see. It’s doubly hard to interpret this move as a sure sign of runaway inflation to come. Earning 1.5% interest won’t even cover anticipated inflation over the next decade.
A rise in inflation expectations isn’t even to blame for the move in rates. Survey data and various financial market metrics only call for roughly 2% per year inflation. This is consistent with inflation expectations we’ve seen for years. The idea that the inflation genie is being let out of the bottle is, so far, largely unfounded.
Yet, with the post-Covid economic recovery gaining steam, it’s true the inflation picture is murkier than usual. If interest rates do continue to rise – and if inflation expectations are to blame for it – a silver lining is conservative investors might finally start to earn some decent interest on their money. It’s been a while!
So, is all this inflation talk worthy of concern? Certainly. To be able to enjoy the possibility of higher interest rates, however, your bond portfolio has to get there in one piece. With that, here comes the world’s most boring advice. Diversification isn’t just for stocks. It matters for bonds, too.
