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We’re likely at the beginning of a sea change in the direction of interest rates and the overall bond market, and a recession on the horizon has important implications for bond investors.
In our recent Big Picture episode, Financial Sense Newshour's Jim Puplava looks at where bonds are headed and what investors can do to protect themselves.
Interest Rates on the Rise
The Fed is meeting this week and is widely expected to raise interest rates for the sixth time to 1.75%, with additional rate increases a possibility later this year. Long-term interest rates have steadily risen with a recent sharp increase last fall and many experts believe that a new bear market in bonds has begun.
What this means is, many who are invested in bond funds are losing money in a market from which they’ve been conditioned to expect only falling interest rates and rising bond prices. What are the forces driving this change?
First, growth and inflation are now finally picking up. This is likely going to fuel further action from the Fed. Second, major buyers of government debt — including the Fed itself, as it clears its balance sheet, but also China and Japan — are cutting back on their bond buying.
Additionally, both growth and interest rates are picking up elsewhere, especially in Europe, where the vast majority of negative interest rate bonds were located. Puplava also explained how deficits in the US, which are on track to head back above trillion next year, play an important role in the future trajectory of interest rates..
Inflation Setting In
We’re seeing inflationary pressures appear in the PPI, the CPI, the prices paid component of the ISM, and in import prices, which have a lot to do with the US dollar falling 16 percent from its highs reached in January 2017.
“We've gone from a very disinflationary environment … transitioning towards a more inflationary environment,” Puplava said. “It’s not going to be hyperinflation, but inflation will be increasing. So as long as economic growth continues to pick up and inflation heads higher, the Fed will continue with these gradual rate hikes until they break the markets.”
Eventually, something is going to break, Puplava noted. We'll probably see it first in the markets, he added, and then eventually it will appear in the wider economy.
Signs of Deeper Problems
Right now, the message coming from Washington to Wall Street is to loosen up the purse strings. Deregulation is beginning to be implemented, with Congress easing lending standards, and we’ve had a massive fiscal stimulus in the form of tax cuts.
Contrast this with the Fed raising interest rates and potentially killing the bull market eventually, and we’re looking at some interesting forces coming to play at the same time
What this means is, we may be looking at a possibility of another financial crisis developing, Puplava stated. Bond investors need to keep in mind that companies’ covenant protections are beginning to weaken, and they have weakened steadily for the last nine months according to Moody's.
If we consider the problems with ballooning government debt, it’s a safe bet that it’s also less secure now. State and municipal bonds, a favorite of high-net-worth individuals, may become suspect as well in another downturn.
“The seeds are in place right now for another financial crisis,” Puplava said. “It may not involve a big bank going under because they're better capitalized today. … But debt is much bigger at all levels.”
What Can Investors Do?
If we are facing another crisis, and we’re truly at an inflection point in bond markets, investors need to protect themselves from capital losses.
Fortunately, bond investors have several options to help protect themselves. One is to move into floating rate bonds that have interest rates adjusted upward every time the Fed increases its rates.
Another option is to look at a short-term laddered bond portfolio. Puplava is also using active bond fund managers for his clients and advises against holding long-dated bonds at this point.
“The forces that could lead to another financial crisis are still at work today,” Puplava said. “As long as there's capital floating out there looking for a home, people are going to tap the bond market. … Right now, the ability to borrow at low rates keeps this crisis at bay. However, that won't always be the case.”
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