Beware the Bonds of October

By September 22, 2018 Blog

            When asked in a recent interview whether stocks were overpriced, Nobel Prize winning economist Robert Shiller replied that he thought so, but not in relation to bonds that were experiencing an all out bubble.  In a similar vein, JP Morgan CEO Jamie Dimon stated that he saw yields on 10-year Treasury bonds rising to 5.0% in the next year.

            In my view, their fears regarding the bond market are more than justified.  The behavior of bond prices has been stunning.  To see why, let’s start with some data.  Exhibit 1 plots the yield on 10-year Treasury bonds and 10-year Treasury inflation protected securities, or TIPS, from the January 2003 through mid-September 2018.  The yield on the TIPS is a real yield.  The investor who holds TIPS receives the real yield plus inflation.  The yield on the 10-year Treasury bond is the normal nominal yield.  The difference between the two yields reflects the expected inflation over the next 10 years.  Notice that in 2005, well before the onset of the financial crisis, the nominal yield on 10-year Treasury bonds was about 5.0% and the real yield on the TIPS was 2.5%.  In comparison, the current yield on 10-year Treasury bonds is less than 3.0% and the real yield on TIPS is less than 1.0%.
            The current numbers, in comparison with the earlier numbers, would not be surprising if the economic conditions were slack, but just the reverse is true.  As President Trump like to “trumpet,” unemployment is running near all-time historical lows and economic growth has accelerated sharply.  Whereas one might expect the Fed to be tightening significantly under such circumstances, monetary policy has remained accommodative.  Fiscal policy, on the other hand, has reached unchartered territory.  Despite the fact that the economy is firing on all four cylinders, the Federal government is still running large deficits.  Put all of this together and predicting a return to the interest rate environment of 2005, as Prof. Shiller and Mr. Dimon appear to be doing, seems more than reasonable.  Therefore, investors should beware the bonds of October.  If both real and nominal yields move back toward 2005 levels, bondholders will sustain significant capital losses and stock prices may fall as well.