Today I’m talking about the bond market.
Specifically, what it’s currently telling us about where the economy might be headed.
In fact, we’ve never seen bond yields sound the recession alarm this loudly. 🚨🚨🚨
- How reliable is the bond market?
- What does this mean for retirement savers?
- And how might the current environment impact investment decisions?
I’m answering these questions (and more) in this episode!
Need Tax + Retirement Planning Help?
We specialize in helping people aged 50+ lower taxes, invest smarter, and (safely) create a retirement paycheck.
Our Free Retirement Assessment™ will answer your BIG questions and help you properly evaluate our firm.
Click the banner below to learn more. 👇
How to Listen to Today’s Episode
- Subscribe to the Stay Wealthy Newsletter! 📬
- Stay Wealthy Retirement Show
- Cambell Harvey
- Current Treasury Yields
The Bond Market is Screaming Recession
Taylor Schulte: Investors have choices to make when investing in bonds.
One of those choices is the maturity date of their bonds and/or bond portfolio. We can buy short-term bonds, long-term bonds, and/or everything in between.
Not all that different than buying a bank CD. We can buy a short-term 6-month CD, we can buy a longer term 5-year CD, or we can create a diversified portfolio of CD’s to arrive at our target maturity date.
Short-term bonds, just like short-term CDs, typically pay a lower interest rate than long term.
And that’s because, all else being equal, short-term bonds are less risky than long-term bonds. Interest rates fluctuate daily and it’s hard to know if buying a long-term bond today will appear just as attractive to us in the future when the interest rate environment might look dramatically different.
As a reminder, when you buy a bond, you are loaning your money to someone else. Either a corporation, a municipality, or the government. In return, they’re paying you interest on your loan, just like you would pay interest on money you borrow.
So if you want to commit to taking more risk and loaning your money to them for a long period of time, those entities will typically compensate you for that risk and pay you a higher interest rate.
But, right now, that’s not what’s happening.
Right now, the yield on a AAA-rated 3-month US Treasury bond is about 5%.
On the other, the yield on a 10-year US Treasury Bond is about 3.5%.
In other words, you are getting paid a lower interest rate for taking more risk. The exact opposite of what you would expect.
When this happens, it’s called a Yield Curve Inversion.
Everything we know to be true about investing in bonds gets flipped on it’s head – or inverted.
The safe, short-term bonds are paying a higher interest rate than riskier, longer-term bonds.
Right now, we’re experiencing the most inverted yield curve in history. We’ve never seen short-term 3-month treasury bonds yield this much more than long-term 10-year treasury bonds.
Why is this? What does this mean? How should retirement investors be thinking about their bonds and the broader economy going forward?
Welcome to the Stay Wealthy podcast, I’m your host, Taylor Schulte, and that’s exactly what we will be digging into today.
For the links and resources mentioned in today’s episode, just head over to youstaywealthy.com/186.
So why is this happening right now? Why are riskier long-term bonds yielding less than safer short-term bonds? In short, two things are happening simultaneously.
First, as we know, the Fed has been raising short-term interest rates to combat inflation, driving up rates on short-term bonds. In addition, for the first time in years, cash in a high-yield savings account is actually earning meaningful interest. But, while we are all celebrating the extra interest we’re getting from our savings accounts, there are other much more sophisticated investors who are worried that economic trouble might be around the corner.
Instead of taking advantage of the higher interest rates on cash and short-term bonds, they are instead buying up long-term 10-year treasury bonds. They are predicting that the economy is going to head into a rough patch and, as a result, long-term bond yields will be lower in the future.
In other words, they believe that locking in a 10-year bond paying 3.5% will look pretty attractive in the not-so-distant future, and they want to load up before their prediction comes true. This race to buy longer-term bonds, in turn, has pushed the yield lower, lower than short-term bonds.
According to Cambell Harvey’s research which I’ll link to in the show notes, since 1969, an inverted yield curve that stays inverted for a full calendar quarter has been followed by a recession each time.
And that’s what we have experienced here recently. The yield curve inverted toward the end of 2022 and has stayed inverted through the first quarter of this year.
Like most things in life, nothing is certain. Campbell’s thoughtful research is based on what happened in the past and doesn’t guarantee that it will play out exactly the same way in the future.
In fact, Campbell Harvey, the person who discovered the yield curve inversion indicator, believes his model might have a false signal and may not be as reliable in today’s environment.
He states three reasons for the potential lack of reliability:
1.) Number one, he notes that unemployment remains low. Specifically, according to his comments on April 4th which I’ll link to in the show notes, there are 1.7 job openings for every unemployed person. In addition, the tech sector is responsible for most of the current layoffs, a sector that had a skyrocketing hiring rate over the last three years. So, their current layoffs, in his opinion, are just walking back some of the excess hiring they did.
2.) The second reason he shares for why the yield curve indicator may not be reliable right now is that Americans’ balance sheets are much healthier today than they were leading up to the last prolonged recession we experienced in 2008/2009. Even if housing prices continue to suffer in the short term, record low mortgage rates that consumers have locked in coupled with their healthier balance sheets, in his opinion, likely won’t cause the same type of catastrophic situation that led to a recession.
3.) The final reason is that everyone knows about the yield curve indicator. It’s hard to miss someone talking about the yield curve inverting and being a predictor of recessions. Since everyone is keeping an eye on this indicator, his theory is that businesses are watching and being more cautious as a result. Instead of getting caught off guard, they are being proactive and making changes in advance knowing that the bond market might be signaling trouble ahead.
All that being said, Campbell believes that a recession could still occur if the Fed isn’t careful and continues to be overly aggressive with rate hikes. So, once again, all eyes continue to be on the Fed and what their next move might be. If they happen to navigate all of this properly, it is possible that they find a way to combat inflation while also avoiding a recession.
Predicting whether go into a recession or not isn’t the purpose of today’s episode. The purpose is to try and make sense of these headlines – the same headlines we see show up every few years – so we can improve the chances of staying the course and staying committed to our long-term plans.
Knowledge is power. I think it’s important to understand how the bond market works, what a yield curve is, what it might be telling us, why we’re getting paid less to take more risk, and why we shouldn’t make dramatic changes to our plan based on predictions about the future.
It’s a breath of fresh air to me when you have an academic like Cambell Harvey – or Bill Bengen who coined the 4% rule – acknowledge that history isn’t always perfectly indicative of the future. That our plans and our decisions can be fluid. That perhaps the yield curve indicator is less reliable today or that the retirees could actually withdraw more than 4% using more current assumptions.
But the current state of the markets still requires retirement investors to make some important decisions. Or, at least, feel comfortable with the decisions they’ve made and the plan they currently have in place. Should retirement savers buy short-term bonds and capitalize on higher interest rates? Should they buy long-term bonds to better protect their nest egg against a recession or catastrophic event? If the safest bonds in the world are currently yielding 3-5%, what does that mean for expected returns from stocks and other asset classes?
We last covered the inverted yield curve here on the show in September of 2022. And in that episode, I attempted to answer some of these questions. Given that we’re still talking about the yield curve today, and more and more investors are waking up to the strange reality we’re living in with regard to bonds, I wanted to replay a short segment from that episode.
Just note that, while the yields I quote in that episode are slightly different than where things stand today, the same comments and principles apply.
Now, even though an inverted yield curve doesn’t necessarily guarantee a recession is around the corner, economic officials often pay close attention to bonds and interest rates and can be influenced to take action when the curve inverts in an effort to try and avoid a catastrophic event. As noted in recent episodes, the Fed is in a tough position at the moment and time will tell if the policy response to the current economic conditions will prevent a recession or at least mitigate its severity.
Until then, investors still have decisions to make with their money. And with the one-year US treasury yielding more than a 10-year treasury, many investors might be wondering what the catch is. Why would anyone buy a 10-year bond? Shouldn’t they just put their bond allocation in one-year treasuries since they’re yielding more?
To help arrive at an answer to these very logical questions, we have to recognize that although treasury bonds don’t contain investment or credit risk, they aren’t 100% risk-free.
For example, if I buy a 10-year US treasury bond yielding 3.5%, I know the exact outcome of my investment every year for the next 10 years and I can build a plan around that. That certainty can be valuable for a certain investor with a certain set of goals.
On the other hand, if I buy a one-year US treasury bond to capture the slightly higher yield of 4%, it’s anyone’s guess what my options will be when I go to reinvest my proceeds in 12 months. What if a one-year treasury in 12 months is only yielding 2% at that time? That previous 3.5% yield on a 10-year bond is now looking pretty attractive to me. In fact, if that were to happen, I may now be tempted to buy a longer-term bond with my proceeds.
Let’s say I buy a 5-year bond with my proceeds because I don’t want to get stuck again in 12 months. But shortly after buying, interest rates spike and now my 5-year bond isn’t looking like such a great choice. You can see how this one short-term decision can spiral into a series of emotional, challenging, and sometimes costly decisions in the future.
My guiding philosophy, in life and in investing, is to focus on things we can control. We can’t control where interest rates will be in the future and it’s impossible for us to know if buying a one-year bond today is better than buying a 10-year bond. This is why I prefer to own and hold thousands of bonds with different maturities over long periods of time, helping to reduce interest rate risk and, maybe more importantly, reduce the odds of me getting in the way and becoming my own worst enemy trying to outsmart the markets.
“Over a long period of time” is a key phrase there. Because in retirement, creating an income stream from our investments for the next 30-40 years is a long period of time. And trying to time the bond market and obsess over how to take advantage of an inverted yield curve to determine what maturity bond to buy next, rarely matches up with the goal of creating a consistent, reliable retirement paycheck for the next 30+ years while also ensuring we don’t run out of money.
There are more important decisions, in my opinion, to be making than how can I take advantage of an inverted yield curve over the next 6-12 months, especially when you can invest in thousands of high-grade bonds through an ETF or mutual fund that costs almost nothing.
Yes, it’s not fun to see the principal value of your bond fund decline here in the short term, but again, we aren’t investing for the short term. Most retirement savers (and retirees) aren’t investing for the next 12 months or even 10 years. A 65 year-old entering retirement today is investing for the next 30 years. And just like stocks, we can’t let short-term events cause us to react and make emotional changes that can have negative long-term impacts.
Ok, two final things I want to touch on before we part ways today.
First, I want to point out what the current state of the bond market and, specifically, the risk-free rate means for your overall investment plan going forward.
The risk-free rate, the 4% you can earn on a one-year treasury bond, should be your current starting point today for any investment you’re considering. In other words, if you’re going to take any risk with your investments, you’re going to expect something more than 4%. This means that riskier asset classes like stocks should have higher future expected rates of return today than they did yesterday or a few months ago. Otherwise, nobody would invest in them.
Nobody would invest in riskier asset classes if they didn’t expect a return that properly compensates them for the risk they are taking above and beyond US treasuries. So, keep this in mind as you evaluate your asset allocation and financial plan and look to make any necessary investment changes going forward. Just take note of how quickly interest rates can move.
The one-year treasury is yielding about 4% today, and that might be your starting point today, but that can change tomorrow or next month. So don’t latch onto this 4% number we’ve discussed today.
Second, while the uptick in short-term interest rates may not change your long-term asset allocation decisions, it may present an opportunity to improve your cash management strategy. To put this opportunity into perspective, the one-year US treasury was yielding 0.40% at the end of 2021. At the same time, the annual headline inflation rate was around 7%.
Today, the risk-free rate is in that 3-4% range, and annualized headline inflation sites around 8%. So if your cash is managed appropriately, you’re able to better protect your purchasing power today given higher interest rates.
Unfortunately, it takes some extra effort to do so because the big banks you know by name aren’t passing these higher interest rates off to their customer. You’ll either need to leverage an online bank like Ally or Capital One or consider buying individual US Treasuries as a cash alternative. Just remember, that unlike an FDIC money market provided by an online bank, US treasuries do fluctuate in value day-to-day. So, if you buy a one-year treasury as a money market alternative, you’ll want to commit to holding it until maturity.
We’ll end there for today. As always, if you have any questions or comments, shoot me an email at email@example.com.
And to grab the links and resources from today’s episode just head over to youstaywealthy.com/186.
Thank you, as always, for listening and I will see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.