Q1 2021: PFM Quarterly Commentary
Many investors approach the securities markets as largely mathematically driven instruments for which one assumes certain levels of risk to potentially grow wealth over time and/or to participate in short-term speculation. Now, while we subscribe to the former approach, in truth, we also enjoy the soap opera like storylines which occur from time-to-time. For a moment let us pay homage to a few memorable sagas which played out over the past three months. Remember the real-life David and Goliath story as small retail traders banded together to drive up the stock prices of Gamestop and AMC, forcing large Wall Street hedge funds to take it on the chin for betting so heavily against these companies. Then we watched a riveting suspense thriller which featured the global supply chain as the protagonist. It was unknown at first whether it would be days or weeks before the mega container ship Ever Given, measuring in at 1,312 feet long and 220,000 tons, would be freed after running aground in the Suez Canal. All the while, it was creating a nautical traffic jam akin to rush hour on Interstate 405. And let’s not forget the feel good rags to riches narrative of scores of newly-minted Bitcoin millionaires buying Lamborghinis while still living in their parents’ basements.
While those storylines and others primarily captured investors’ attentions, a truly historic and monumental event occurred that largely went unnoticed. The investment community at-large almost exclusively references stocks when discussing “the market,” certainly because they are more entertaining due to their volatility. However, for the purposes of the following discussion, we must differentiate the term “market” to include numerous other asset classes and geographies. Let’s first turn our attention to the U.S. bond market, which by some measures, is nearly 50% larger than the stock market and many times more critical as it serves as the transmission mechanism for the global economy. Given its importance, a major event in the bond market should be front page news. But alas, just such an event occurred and was again relegated to the back page.
Arguably one the most important securities in the world is the U.S. Ten Year Treasury Bond. This one financial instrument is responsible for facilitating global trade, maintaining the U.S. Dollar’s reserve currency status, determining mortgage rates, and funding deficit spending. Remarkably, this security has been in a forty-year long bull market which is loosely defined as a continuous period of price appreciation without experiencing a 20% decline. The longer dated Treasury Bond market (represented by the Bloomberg Barclays US Treasury Index) has been in this bull market since 1981 when the Ten Year Treasury interest rate peaked at 16%. For context, 1981 was Ronald Reagan’s first year in office, “Endless Love” by Diana Ross and Lionel Richie topped the charts, and Dallas was the country’s top-rated show.
Ok, now fast forward back to present day. On March 18th, 2021, the Treasury Bond Index registered its first 20% decline from the previous high reached exactly one year earlier, thus ending one of the longest and most prolific bull markets in history. Most of the Treasury bond market’s decline came in 2021 by registering its largest first quarter drawdown since 1980. It’s important to keep in mind that this prolonged bond bull market often soothed financial markets in times of stress, helped propel the global economy, and permitted higher equity market valuations; simply put, the impact cannot be understated. Rising bond prices (meaning falling interest rates) encourages spending, borrowing, investing, and speculating. There are generations of investors who have only experienced the benefits of falling interest rates.
While many prematurely and incorrectly have called the death of the bond bull market over the years, a 20% price decline is the first objective and measurable confirmation. However, it is critical to understand that the bond market’s path from here is anything but certain and a return to the old price highs is possible. Still, when an event of this magnitude occurs, it should certainly grab your attention.
What caused this forty-year long bond bull market to end? As you may recall, the recipe for inflation can be simplified to the quantity of money multiplied by the velocity of money; essentially, how quickly money circulates through the economy. Regarding the first ingredient, we have routinely chronicled the extraordinary increase in money supply, nearly by 200%, since the start of the Great Recession in 2007. In fact, more money was created in the U.S. over this short time span than the cumulative amount of all the preceding years. Yet, inflation remained subdued thanks in part to an offsetting decline in the velocity of money, which fell by nearly half over that same period thanks in part to the Federal Reserve incentivizing banks to hold excessive cash on its balance sheets rather than lend it out.
So, is this the beginning of a new paradigm of money velocity? Deficit spending has been in vogue since the Great Recession, but has exploded since the onset of the pandemic. Another $1.9 trillion in COVID-related relief was passed into law shortly after the inauguration of the Biden administration and, at the time of this writing, the President is preparing to unveil a $2.3 trillion infrastructure bill which could presumably increase in size as it moves through Congress. And since there remains many other initiatives that both sides of the aisle have promised their constituents, we expect the spending splurge will last for a long time. To remain accommodative to the trillions flowing from Washington, the Federal Reserve recently outlined its intention to keep the Federal funds rate at zero percent into 2023.
At this intersection of accommodative monetary policy, unprecedented fiscal stimulus, a glut of savings, and the post-pandemic reopening, many experts predict that increased money velocity is a foregone conclusion. These prognostications were accompanied by a sharp increase in inflation expectations, which initiated the bond market’s steep selloff. Many will point to the government’s Consumer Price Index (CPI) as continuing to reflect very low inflation (currently only 1.7%), but there are other inflation metrics telling a very different story. Single family home prices are soaring across the country with the cost of lumber surging to all-time highs. Critical raw materials such as copper, crude oil, corn, livestock, palladium, soybeans, and wheat hit multiyear or all-time highs during the quarter. Shipping rates and import prices also hit multiyear highs. It is no wonder consumer inflation expectations and the bond market’s forecast for longer-term inflation reached their most elevated levels in six years and eleven years, respectively.
Real world price data predicts that higher inflation is coming, and in some cases, is present already. The Federal Reserve acknowledges the phenomenon by saying rising inflation is transitory and still could move meaningfully higher. In essence, they are “comfortable” with you paying more for everything if they can manufacture the desired rate of corresponding economic growth. We shall see.
Feel free to be captivated by this coming quarter’s investment-related sagas, but remember, always keep your sights squarely focused on the long-term. That’s how goals are realized and that’s what we’ll be doing.
Peak Financial Management
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