Special Bonus Discussion Topic

We are supposed to talk about taxes this week, but I’m going to do everything I can to avoid it. I’ll even go so far as to give you a Special Bonus Discussion Topic, even though I generally try to stay on the taking side of bonuses. Here it is:

What is up (or down?) with the interest rates on bonds in the United States?

I am a self-certified non-expert on the matter, but after last week's blog, I just can’t stop thinking about this. Why would someone invest in a 10 year bond that returns just 2.64%? In a best case scenario where inflation remains below average, there is hardly any gain at all. For the 5 year bond at 1.65%, the investment stands to lose money after adjusting for inflation.

Having devoted my amateur thinking to this for at least a few minutes, it seems to me that there are really only two reasonable explanations for this:

A. People think there will not be any inflation (or even, that there will be deflation)

B. The bond market is in a bubble

Perhaps if I were an expert, I would be able to consider Option A. In that case, I would suggest that if we compare the rates between regular bonds and inflation-index bonds (“TIPS”), we can infer what the market thinks about inflation, like this:

	Regular	TIPS	Difference
5 Year	1.65%	-0.50%	1.15%
10 Year	2.64%	0.52%	2.12%

The logic beyond this comparison is that the investor who buys the regular bond instead of the inflation protected bond thinks that inflation will be less than the difference between the interest rates. If he thought that inflation was greater than the difference, he would have bought the inflation protected bond and not bothered worrying about the risk of inflation at all.

This means that the market of investors believe that inflation in the next 5 years will average less than 1%, and no more than about 1.75% over the next 10 years. Inflation this low happened in 1953-1965. It is certainly possible that it could happen again; although since 2008, inflation has averaged 2%. In general, markets tend to return to the average, but you never know when exactly that will happen.

Another possibility in Option A is that we are headed for a period of “deflation” like what happened in the Great Depression. I have trouble even thinking about what this would mean. Maybe it’s because I always had trouble reciting the alphabet backward.

I’ve read what some of the experts say about deflation, and they are pretty sure that the U.S. Treasury will do everything it can, including “quantitative easing”, to “stave off” inflation. I think you should never trust anyone that uses the phrase “stave off”. However, in this case I will make an exception because “quantitative easing” sounds both pleasant and harsh at the same time, and I’ve always liked sweet and sour chicken.

The other possibility is Option B, which is simply that there is no logic to these interest rates and the bond market is in a bubble. For this to be the case, we would need to demonstrate that the two most important symptoms of a bubble are present. First, there would need to be someone who would claim there is a bubble while most people do not think so. Second, we should be able to make the case that “this time is different”.

I have singlehandedly accomplished the first criteria. (You’re welcome.) For the second, plenty of experts have commented about the unique market conditions that we are facing, but I am the only one to propose this baseless conjecture:

This time is different because of the aging baby boomers. As the population ages, we have more people than ever before who are rebalancing their portfolios to place more and more money into bonds. As this happens – and it will continue for a while as the baby boomers are just starting to retire – the bond prices will remain high (and yields low) like they are today.

I thought this conjecture was so compelling that I did everything I could to prove it. As it happens, the evidence points in the opposite direction, as money has actually been moving out of bond funds into stock funds in the past few years.

Maybe it’s a bubble or maybe this time is different. Either way, I simply can’t justify investing in bonds in the U.S. at these prices. In my U.S. accounts, all the money I have allocated for “bonds” is sitting in cash.

What say you, loyal readers?