Bond prices have fallen sharply, causing head-scratching among some analysts who wonder why fixed-income investments should be losing so much value while inflation – the traditional enemy of bonds – is still muted.
In my opinion, it’s all about signs of a stronger U.S. economy. This time around, rising inflation has not been the enemy of bondholders; the damage has been done by an improving outlook for the world’s largest economy.
Let me explain. When you buy a traditional bond, you are guaranteed a certain interest rate as a reward for surrendering your money for the bond. This reward actually consists of three sub-rewards.
First is the reward for postponing consumption for the future: This is the real interest rate. Second is the reward for possible loss of purchasing power – an offset for expected inflation. Third is the reward for possible loss of capital – the risk premium.
When dealing with government bonds, you can ignore the risk premium since there’s essentially no chance of default. So let’s focus our discussion on the real interest rate and the inflation premium.
In the short run, the real interest rate is driven by the business cycle. When the economy expands, the real interest rate rises and when the economy contracts the real interest rates falls.
Inflation is also driven, at least in the short run, by the intensity of economic activity. If activity picks up, it puts pressure on labour and commodities markets, among other things, and raises prices.
Right now, inflation and expectations about future inflation are subdued by any measure. Thus current inflation is not the reason that nominal interest rates have risen and bond prices have fallen.
But real interest rates are going up. Recall that bond prices move in the opposite direction to interest rates. Over the past couple of months, real-return bonds (a special type of bond that pays a fixed return on top of inflation) have lost value, indicating a steady climb in real interest rates.
What’s caused this run-up in real interest rates? Probably signs of a pick-up of economic activity in the U.S.
New house sales are up, as are car sales. Consumer and small business confidence is rising. State and local governments have started to hire again. Initial jobless claims are dropping fast. The energy boom in the U.S. is also adding to confidence.
This has not yet translated into fears about inflation. Again, you can turn to the bond market for a reading – real return bonds have lost much more over the past two months than traditional bonds, which indicates that while real interest rates are rising fast (hurting real-return bonds), the impact on traditional bonds has been more muted. This suggests that any worries about inflation, which can gut bond returns, are muted.
Bottom line: The U.S. economy is on an upswing putting upward pressure on real interest rates leading to an increase in nominal interest rates, too. But the increase is not due to increased expectations about inflation. It is because of an increase and expected increases in the real interest rate.
What does this mean for the bond and stock markets? It is bad for nominal and real return bonds (especially the latter). It’s good for companies and stocks that can grow profits, but not so good for high-yielding stocks and real estate, because higher payouts on bonds will lure investors away from income-producing equities.
Now, if you are a contrarian and believe that the signs of economy pick up are premature and economic activity will peter out over the summer months, then investing in real return bonds may be the best strategy, because their recent decline has built in an expectation of a sharply accelerating economy. If that doesn’t come to pass, real rates will fall back and real-return bond prices will go up.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.