Takeaways
- 4% ten-year Treasury bond yields: Could history repeat?
- Lessons from Paul Volcker’s inflation battle
When I was much younger, I worked as a bond salesman for a small regional bank in the southwest. I sold some short-term T-bills to yield 17% and some ten-year T-bonds to yield 14%. Paul Volcker, the Fed chairman at the time, had reduced inflation dramatically but the bond market had not yet accepted that new reality and kept interest rates very high for a while after Volker achieved his lower level of inflation.
Today, we could be facing a very similar scenario. At the present time, 10 year Treasuries yield about 4.35%. Since there is an inverse relationship between a bond’s rate of interest and its price (i.e. higher rates mean lower bond prices), an increase in rates from the current rate of 4.35% to 14% would generate massive losses in a portfolio that is holding said bonds.
How could this happen?
Our huge budget deficit means that the US Treasury must continue to sell more and more debt. In fact, more of the Federal budget now goes to interest expenses than the department of Defense.
However, the problem is that Increased debt issuance typically requires higher yields to attract buyers.
On top of this existing problem, the current administration is proposing a large tax cut that will not be covered by any increased revenue. This means that the deficit will grow even larger, and the country may wind up on the hamster wheel of ever-increasing interest expenses.
Where are Treasury Bonds today?
Both the governments of Japan and China own trillions of dollars of US Treasury debt. The nightmare scenario is that these two foreign governments decide to start selling their US Treasury holdings while the market is dealing with the oversupply of Treasuries from the tax cut efforts. In this scenario the selling pressure from them could overwhelm the Treasury market, further driving yields upward.
So what’s the potential impact if bond yields skyrocket and bond prices collapse? First, the US banking system would take a huge hit since it is a large owner of US Treasury securities. However, the bigger issue is that the interest rates on US Treasury securitiesset the minimum return expectation for all investments.
Therefore, stocks, bonds, real estate and all other potential investments would all likely face significant valuation headwinds, leading to a price decline. And in such a scenario the most likely hedges (i.e. investments that would most likely retain their value) would be gold, other commodities and foreign securities.
What about the US Dollar?
In a bond market Armageddon scenario as described above the value of the US dollar would also likely face significant downward pressure. And a weaker dollar would also be good for gold, foreign securities and commodities.
Portfolio Hedging
Investors should consider aligning their portfolios with their risk tolerance, potentially adding gold, commodities, or international assets as hedges.
Since the foregoing description has only been experienced in third world countries, it is hard to know exactly how it would play out in the home of the global reserve currency.
In my opinion, given the current environment investors should re-evaluate their own portfolios and ensure the risk in the portfolio aligns with their own risk tolerances. For those looking to potentially hedge some of the downside there are opportunities to invest in the assets mentioned above, all of which can provide downside protection while still offering the potential for capital appreciation.
Please read important disclosures here.
A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out some of our webcasts.
© Defiant Capital Group
Read more commentaries by Defiant Capital Group
