Betting on fixed income:
What if I’m wrong?
Allocating between 10-30% of your capital to fixed income is a reasonable strategy
By Mark A. Stairs
April 10, 2023
Ray Dalio, founder and retired Chief Investment Officer of Bridgewater & Associates, the world’s largest hedge fund (160B assets under management), characterized cash as trash in a recent interview. I can’t say I disagree with his assessment given his simple argument that 90-day T-bill rates, despite their recent rise, remain well below the inflation rate.
Furthermore, Mr. Dalio made cautionary statements about longer-dated bonds, which have also risen in yield, yet remain below current inflation as well. Despite his cautionary words about bonds, he’s calling for a near-term rally in bond prices as fears of recession mount. How can Ray’s seemingly contradictory statements co-exist? Simply put, bond market participants seem to wholeheartedly believe the Federal Reserve’s rhetoric about returning inflation to its 2% target level.
A Recession Would Help the Fed’s Cause
Many believe the Fed will need to induce a recession to get inflation back down to its target of 1 or 2%. They believe that once inflationary pressures have subsided, this will allow the Fed to immediately pivot to lowering rates to help a sinking economy. There is historical evidence to support their case. Indeed, the last time inflation was elevated, albeit at much lower levels, was in mid-2008 when US CPI got to 5.5% before falling precipitously into negative territory (–1%), just nine months later.
90-day T-bill rates, despite their recent rise, remain well below the inflation rate.
Of course, it took a near collapse of the global banking system to correct a 5% inflation problem. What will it take to correct an 9% inflation problem this time? Inflationary pressures appear to have peaked in June 2022 at 9.1% in the USA and 8.1% in Canada and currently stand at 6.5% and 6.3% respectively.
While recent CPI data is certainly moving in the right direction, will it settle anywhere near the Fed’s 2% target? Is it falling fast enough to prevent consumers and bond holders from being eaten alive for a third year in a row? Bond market participants certainly believe so, although I’m not so sure consumers are quite as optimistic.
Still an inflationista, but willing to hedge my bets
Personally, I am still leaning towards more persistent inflation that averages a higher rate in the current decade versus the 2% average rate we enjoyed for the previous two decades (see Paradigm Shift, TFI Fall’22).
However, as fiduciaries, it would be inappropriate of us at the RS Group to position (bet) the entirety of our client portfolios on this inflation thesis. Good money managers must always ask themselves: What if I’m wrong and what would be the magnitude of the impact on client portfolios? Positioning one’s portfolio 100% for a much higher inflationary environment could be disastrous should a persistent deflationary/disinflationary environment evolve.
‘Many believe the Fed will need to induce a recession to get inflation back down to its target of 1 or 2%.’
Because I don’t truly believe that policy makers would allow a deflationary bust to occur, I remain convinced that the path of least resistance for them remains an inflationary one. That is, the printing of money to fund government deficits through central bank bond buying. This avoids the embarrassment of default, politically unpopular austerity measures and tax hikes.
Placing Your Bets
No doubt, if you are buying fixed-income products today, you are betting on lower inflation, as no (quality) product currently pays a rate that exceeds inflation. Nonetheless, given the rapid rise in rates in 2022, a falling inflation rate and the possibility of even steeper declines should we enter a recession, investors should be making a reasonable bet on bonds in anticipation of lower inflation.
Depending on your personal risk profile, tax bracket, the availability to shelter interest-bearing products in registered accounts, etc., allocating between 10-30% of your capital to fixed income on the shorter end of the yield curve (1-5 years) is a reasonable strategy at this juncture.
‘While recent CPI data is certainly moving in the right direction, will it settle anywhere near the Fed’s 2% target?’
If inflation moderates, yet proves sticky in the 3-5% range, then you’ll simply preserve purchasing power on products yielding 4-5%. While, if it falls back below the Fed’s 2% target, or even goes negative for a period in the event of a deflationary bust, then those gov. guaranteed 4-5% yields will look great. But until fixed-income products actually offer investors a real yield (i.e., a rate that exceeds the inflation rate) I would not be inclined to make an allocation much beyond 25-30%.
Should real rates of 1-2% materialize in the coming quarters, then investors can get more aggressive with respect to fixed income. Of course, this would take inflation moderating substantially from here and longer-term bond yields of 5-7%, something we have not seen in decades.
Furthermore, this would be a great opportunity for older, retired investors to shift back to a more balanced mix (40/60) after being forced into the uncomfortable position of being growth investors for many years during a record-low interest rate environment.
Central bankers are not your friend.
Mark A. Stairs, B.Eng., CFA. Following the completion of a mechanical engineering degree Mark entered the financial services industry in 1993, finally joining Nesbitt Burns in 1997. Mark is also an avid tennis player and enjoys working on his farm where he grows pine trees.