Obviously, January and February were very volatile months for stocks. It was also quite volatile for bonds. Although it was the kind of volatility that goes in a straight line. Bond prices have been going straight down.
In November, the US Treasury issued bonds due in 10 years that paid 2.25% coupon interest. They were priced at 100. The yield, of course was 2.25%. Today that same bond is selling for a yield of close to 2.90% at a price of 94.5. In other words, if you bought the 10-year US Treasury Bond when issued in November, you would have a principal loss of over 5% in three months. Similar moves have occurred at shorter maturities along the yield curve. The five-year Treasury issued in November has a coupon of 1.65% and has declined in price about 2.5%. When folks get their brokerage statements this month it will become apparent.
Inflation expectations have spooked the bond market. For the last several years, investors have gotten used to inflation being close to zero. Now, they are having to adjust to a new reality where inflation appears to finally be approaching at least the 2% level that the Federal Reserve has been seeking for so long. Bond prices are adjusting to this change. Historically, bond investors have felt that they should receive a “real” return; that is a yield that is positive after subtracting inflation. The longer the term of the bond, the higher the real return should be.
The 10-year Treasury has usually required a “real” return of close to 1%. So, with inflation expectations now running at 2%, it should be no surprise that the required yield for 10-year Treasuries in this market is 3%.
That is why Jeffrey Gundlach, head of the big bond firm Doubleline, said this week that bonds were now priced where they should be. But, that doesn’t mean they are priced where they will be in the future. That depends on whether inflation expectations continue to rise. Mr. Gundlach said in his interview that in his opinion it was likely that expected inflation would continue to increase over the next year.
Clearly, the Federal Reserve is concerned about letting the inflation genie out of the bottle. They raised short term rates three times last year and are on record saying they will raise them at least three times in 2018. And, that was before the recent tax cuts and consequent increase in the expected Federal government deficit over coming years. Fiscal policy is now quite stimulative even with unemployment quite low, corporate spending quite high, and inflation rising. If the Federal Funds rates is raised to 2.5% over the next year, it is a pretty good bet that the yield on the 10-year Treasury will rise at least 0.5%. You could lose another 3-5% of principal buying those bonds today.
So, it is still a bit early to commit fully to bonds. But, they are becoming more competitive with stocks. If 10-year Treasury yields get to 3.5%, investment grade corporate bonds will yield about 4.5%. Low quality bonds yields will increase more than Treasuries as we get later in this cycle and could go back up to as much as 8%. By summer we should know more about Fed policy and inflation. That should be a good time to start averaging back into the bond market.
As for stocks, we still believe in our forecasted trading range of 2400-2900 for the S&P 500 this year. After all the fun, we are solidly in the middle of that range at 2747. There has been some improvement in our sentiment factors as the brief selloff helped diminish some of the excessive optimism out there. But, rising rates and inflation will have an impact on stock valuations.
By the way, Warren Buffet published his annual letter to his stockholders this weekend. He suggests that in the short run, valuation is a problem. He has $116 billion that he would like to commit for a big acquisition for Berkshire Hathaway. But, he says, “prices for decent, but far from spectacular businesses, are at an all-time high.“ As always though, Mr. Buffet is a long-term Bull. He reminds us in his letter that “In America, equity investors have the wind at their back.” Mr. Buffet knows what he is talking about!