On Wednesday, I wrote about the positive and negative of rising interest rates for bond investors. I also promised a follow-up to share my opinion on where interest rates go from here so let’s dive into that.
Note: In both today’s and the recent commentary, I’m addressing treasury bonds, specifically, not to be confused with corporate bonds, which I hold relatively very little of across client portfolios as I’m purposely avoiding credit and default risk at this point in the market cycle.
In short, I believe by the time this market cycle is complete over the next couple years, interest rates on 0-10 year treasury bonds could fall back towards zero again. This would imply a great investment opportunity in an asset class that is widely hated at the moment! But that’s how it normally works doesn’t it?
Obviously, if inflation is sustained for a prolonged period then rates will continue higher, but I don’t think that’s the likely outcome. Therefore, this is really a forecast about inflation / deflation over the next couple years.
I continue to believe the U.S. will end up experiencing a deflationary debt deleveraging cycle. In fact, I would not be surprised to see inflation peak at around the current 8.5% level and begin rolling over in the latter part of the year.
Here are some reasons for my view:
Point #1:
Stimulus has ended and supply chains are being repaired.
We’re experiencing significant inflation because trillions of dollars were created out of thin air during the pandemic and injected into the economy while supply chains were simultaneously disrupted. This resulted in “more money chasing fewer goods / services” (i.e. inflation) as I discussed last year.
That’s the opposite of what is happening now. Stimulus has ended, money supply just began contracting and supply chains are being restored resulting in less money chasing more goods (i.e. deflation).
Point #2:
Economic activity pre-pandemic was already weakening with the first decline in global trade activity outside of recession. COVID-related stimulus ironically provided a temporary boost to “save” an already weak economy, but there’s no reason to believe we won’t revert back to pre-pandemic trend growth, which was anemic in the scheme of historical growth rates.
Point #3:
The U.S. economy is saturated with debt. This implies continued growth in additional debt / money is less likely or, at least, expanding at a slower pace.
Total debt to GDP today is around 370%, near a historical high. This ratio stood at just 150% in 1980 combined with very low stock valuations, which implied enormous potential investment and economic growth going forward from that point. Sure enough, the 1980s and 1990s were very robust producing a couple of the greatest decades in history.
We’re now on the other side of that debt / growth mountain (see chart below) combined with the most extreme stock market valuations in history (as of the beginning of 2022). The polar opposite of the conditions present in 1980.
A deceleration / contraction in debt is deflationary.
Debt contracts, or grows more slowly, for a couple reasons: (1) borrowers are tapped out and don’t want to / can’t borrow anymore, (2) lenders are skittish and tighten lending standards, and/or (3) borrowers begin defaulting on debt at higher rates.
Point #4:
Fiscal stimulus provides a short-term, temporary boost but it does not create long-term sustainable growth and expansion unless the government is funding infrastructure. Stimulus simply pulls demand forward and increases prices from what they would otherwise have been absent the stimulus.
Point #5 (related to Point #1):
Inventories will be built back up as retailers over-ordered and consumer demand wanes causing retailers to discount prices to move inventory.
Consumer demand is waning as household personal saving rates are dropping back to pre-pandemic levels, credit card balances are rising, borrowing has become more expensive and inflation is eating into discretionary income / spending.
“Target is canceling orders from suppliers, particularly for home goods and clothing, and it’s slashing prices further to clear out amassed inventory ahead of the critical fall and holiday shopping seasons.”
“Other retailers including Macy’s, Kohl’s and Walmart cited rising inventories when they reported their quarterly earnings results last month. Walmart said at its annual shareholders’ meeting on Friday that 20 percent of its elevated inventory were items the company wishes it never had.”
Please understand that this is NOT a forecast for the next several months as that is impossible but for the duration of this market cycle. Please also understand this is merely a forecast. I feel strongly about this and support my forecasts with time-tested evidence, but economic predictions can be tricky as they are largely a prediction of human action and human response to various environmental stimuli. Additionally, politicians can step in with a new stimulus program at anytime, which could change the forecast.
Disclosures:
Past performance is no guarantee of future results. All investments maintain risk of loss in addition to gain.
Data from third-parties is believed to be reliable but accuracy is not guaranteed. Much of the data used to interpret the markets and forecast returns are often at odds with each other and can result in different conclusions. Many different factors impact prices including factors not mentioned here.
This is not investment advice but merely a general commentary. Individualized investment advice cannot be provided until a thorough review of your unique circumstances and financial goals is completed.
Views provided here are current only as of the moment of posting and are subject to change at any time without notification.
