Inflation Or Not, The Bond Market Is No Safe Haven For Investors

Everyone was eager to put 2020 behind us, yet the Covid hangover lingers. Fiscal and monetary policy prescriptions, taken to address the impact of the virus, threaten to exacerbate challenges for investors and longer-term economic health – all while the threat of inflation is the elephant, if not the vulture, in the room.

While 2020 was a year we’d all like to forget, the impacts of COVID-19 still loom over 2021 and beyond. In less than a year’s time, the yield on 10-year Treasuries has soared from 0.52% to 1.74%, then retreated to near 1.30%. Neither of these situations are good for bond holders. If yields remain low, the interest bond holders receive will fail to outpace inflation. If yields rise, the values of their bonds will fall. It is a no-win situation for bond holders.

“Modern Portfolio Theory,” an ill-suited name for something conceived in the 1950s, and its assumptions based on traditional asset correlation relationships, are cracking under the pressure of this new environment. As such, the traditional 60/40 stock to bond portfolio is dead going forward.

As investors assess the rest of this year and beyond, concerns over inflation cannot be easily dismissed. At a point when inflation is picking up, and considering the potential for further lockdowns and supply shocks due to the Delta variant, blowing out budgets with massive government cash injections into the economy may not be advisable to curb inflation, to say the least. Meanwhile, we have been in a 40-year downtrend in interest rates and commodity prices. It appears as if both may have bottomed last March. Investors must now take into account a real possibility of a rising trend in rates and prices. Even slight hints of rising rates or tighter Fed policy have sent equity markets reeling in recent years.

Moving forward, much of the responsibility for guiding the growth and inflation within the American economy will pass from purportedly non-partisan experts and PhDs at the Federal Reserve to partisan politicians in Congress and the Executive Branch. So, it is important that investors seriously assess the likelihood and potential impact of proposed spending and tax plans, like a $3.5 trillion budget reconciliation bill, the $1.5 trillion infrastructure bill, the Child Tax Credit, a proposed increase in the inheritance tax, potential increases in corporate and capital gains taxes, state and local tax (SALT) deduction limitations – and the list goes on. The controlling party may have a few reconciliation bullets in their revolver, but it is unclear what will pass or if the markets will tolerate more spending. But for those keeping tabs, the current administration has recommended the highest sustained level of spending since World War II, with annual spending rising from $6 trillion to $8.2 trillion from now until 2031.