The End of the Easy Money Era

In an exclusive research report from early October, Bank of America asserted that we are currently in the "greatest bond bear market of all time." The numerical data appear to support such a claim, as the U.S. Treasuries market has experienced a decline of approximately 24.7% in its value since Treasury yields reached their lowest point in the summer of 2020.

The ETFs tracking the performance of U.S. Treasury bonds have endured significant losses in recent years, especially those focused on long-duration bonds, which are more sensitive to interest rate movements. For instance, the iShares 20 Plus Year Treasury Bond ETF (TLT), managed by BlackRock, has experienced a 50% loss over the past three years. ETFs like TLH or IEF, which follow a similar approach and hold bonds with shorter durations, have also had poor performances during this period.

Why do interest rates have an inverse relationship with bond prices? Well, simply put, when interest rates go up, the bonds issued at previously lower rates become devalued. This is essentially what happened to Silicon Valley Bank, which collapsed earlier this year after its bond holdings were massively devalued.

The problem is, SBV isn't the only entity holding onto the devaluing bonds. In fact, the risks go far beyond the banking sector - plenty of government debt securities are held by financial institutions, foreign governments, corporations...the list goes on.

As we wrote recently, inflation appears to be reluctant to ease, which may compel the Federal Reserve to keep interest rates at historically high levels for longer than anticipated, extending this risk indefinitely. In other words, we are entering a new era in terms of interest rates, inflation, and macroeconomic volatility.

What to Expect from Now On

In its last meeting of September, the Federal Reserve maintained its current interest rates, but it also signaled its anticipation of one more increase by the end of this year and fewer reductions in the coming year than previously suggested. 

The Federal Reserve's future expectations are reflected in the classic dot plot included in its reports. Despite the Fed's aim for further interest rate hikes in 2023, the market does not believe this will happen. This is evident in the implied futures rates collected by the Chicago Mercantile Exchange (CME). Does the market believe that the Fed will let inflation run a bit longer in exchange for avoiding the risk of causing a crash?

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One last point to consider regarding the current bond market is that the interest rate curve remains historically high, with the Fed signaling a possible continuation of its rate hike policy. A rate increase would be highly detrimental to bond and stock prices given the current market expectations. This implies that, regardless of the Fed's final decision in November and December, it may be that it lacks the credibility to continue its policy. 

The Beginning of an Era

The U.S. market went through more than a decade of "easy money," with rates close to 0% and massive debt issuance following the 2008 crisis and then the Covid-19 pandemic. That era is formally over, and we are entering a new one marked by persistent inflation, while at the same time, the market is unable to sustain current valuations if the Fed achieves its goals of curbing price increases. This fundamental contradiction is the sign of the new era.

Persistent Inflation

Mainstream economists like Paul Krugman often avoid mentioning the significant inflation in basic aspects of life such as food and housing in their analyses. Acknowledging this would, in part, imply accepting that the price variation is actually considerably higher than what the Bureau of Labor Statistics reveals, as we've seen in previous articles. The construction of the Consumer Price Index (CPI) is subject to manipulation.

Paul Krugman measuring inflation without considering the price of food & gas, among others items.

One way inflation might be "hidden" is in the way many official statistics are calculated. Data provider Shadowstats calculates inflation using official methodologies used until 1980 and 1990. The changes in the methodology of price measurement that followed included a greater weighting of technological advancements and the consumption of goods and services related to communication or cable. Conversely, in this "model" basket of goods and services, food, education, healthcare, and transportation have had a lower incidence since then. It's not hard to imagine why that might be.

Some reasons indicating the presence of persistent consumer price inflation include the nearly 100% increase in the money supply over the past 10 years, the decrease in money demand, the fact that we observe more significant increases in the primary goods and commodities market (the initial elements in production chains), and higher inflation in the Producer Price Index (PPI) compared to the Consumer Price Index (CPI).

Money Supply measured as M2, which are “fairly liquid dollars” in the economy. M2 has almost doubled in the last 10 years.

With inflation under the rug, relatively high valuations, and a lack of trust in the future policies of the FED, the bond market is simply a clear indicator of the symptoms present in this new era, where the Federal Reserve will have to decide what is more important: the stability of the financial system or the stability of the monetary system.

Where Do We Go From Here?

Ever since the massive QE policies of the Covid era, policymakers have been in a bit of a bind. On one hand, raising rates was necessary to prevent inflation from spiraling totally out of control. On the other hand, raising rates has had its own pitfalls, as we’ve outlined here. Sustained high rates are largely failing to reign in inflation, at least at the consumer level, and are wiping out the bond market in the process . 

Only time will tell how these circumstances will play out over the long term. But a few things are for certain:  one, that the ‘easy money’ era that we had all become so accustomed to has finally and definitively come to an end. Two, the inflation we’re currently experiencing isn’t going anywhere for the foreseeable future. And three, that investors will have to think outside the box in order to find returns that are able to keep pace with inflation and preserve their wealth. 

One place that always seems to outperform during inflation is farmland. Farmland benefits from some of the fundamental characteristics of inflationary cycles: high commodity prices, investor preference for tangible assets, the long-term appreciation of land are just a few of its benefits. To learn more about how you can add farmland assets to your portfolio, click here to get in touch with our staff. 

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