The year 2022 started with a considerable rise in interest rates. As measured by the ETF (BND), the bond market fell around 10% in the first months of this year. In general, short-term interest rates are always below the inflation rate, but that could change as the Federal Reserve plans to increase the discount rate up to 3% at the end of the year. Real long-term interest rates, i.e. the rates after inflation, have also gone from less than -1% to just over 0%. This “real” interest rate measure can be found by looking at inflation-linked Treasury bonds such as those in the ETF (NYSEARC: ADVISORY), which has been down about 7.5% so far.

The bear market has hit virtually all fixed rate bonds, including treasury bills, international sovereign, corporate, municipal and even inflation-linked bonds. There is some spread with lower-rated, longer-dated bonds faring less well, but almost all are down at least 8% to 15% – relatively large losses for the “safe” bond market. “. See below:

The 40-year bond bull market probably died with rising interest rates and inflation. In fact, the recent decline in bonds has been the largest since 1842. The decline was relatively easy to predict given abnormally low interest rates in 2020 and 2021 compared to soaring inflation. Early last year I wrote “BND: The Great Bond Crash Can Only Be Beginning”, “BND: The Cut May Cause Earthquakes in the Bond Market”, and a few others that described this problem and how bonds were likely to fall as the Federal Reserve Ended QE Generally speaking, the bond market is not a free market since the US Federal Reserve, Treasury and foreign peers control most of the market and usually prevent their intentions.

I still don’t see any solid upside opportunity in most bond markets. While interest rates have risen, the bond market’s measure of inflation expectations (currently 2.6%) looks well below the likely actual rate of inflation over the next few years. If the market readjusts its inflation outlook to better accommodate the sharp acceleration in commodities, most bonds could experience another significant drop. However, with real yields now reaching positive territory and the global economy returning to a slowdown, inflation-linked Treasuries, such as those on TIP, could present a much better opportunity.

Why inflation will most likely rise

Inflation-linked bonds are similar to standard US Treasury bonds, but are indexed to the consumer price index. As the CPI rises, inflation-linked bond funds like (TIP) pay the gain and pay a much lower return instead. Technically speaking, the net yield of a “normal” treasury bill and an inflation-linked treasury bill should be the same as long as the bond market correctly accounts for inflation.

Bond market inflation expectation can be measured by subtracting the yield of a standard Treasury bond from its inflation-linked counterpart. For example, a regular 10-year Treasury bond pays a rate of 2.75% today, while an inflation-linked bond pays 0.13%. The difference of 2.62% corresponds to the average rate of inflation expected over the next decade. These measures have increased this year, but the recent extremely sharp rise in short-term Treasury rates (a measure that tracks the Federal Reserve’s planned rate hikes) has dampened inflation expectations. In other words, the bond market currently expects the Federal Reserve’s impending rate hikes (and similar actions) to stop inflation.

See the data below:

The current year-over-year CPI inflation rate is 8.3%, so aggressive action needs to be taken to bring it down to 2.6%. In my opinion, a short-term interest rate of 2.5% to 3% is not high enough to stop it. As President Biden recently released his to plan to contain inflation, I do not believe that these points or measures relate to the root causes of inflation. The Federal Reserve may need to take more aggressive action, but research shows that current inflation is primarily driven by accelerating energy prices. This acceleration stems mainly from years of underinvestment in the sector, making it impossible to maintain energy production levels. However, the Russian oil ban has undoubtedly exacerbated the problem.

For more information on the energy market factor, see “XLE: Windfall Profit Tax Risk Overrides Bullish Oil Scenario” or “USO: Why Crude Oil May Be On The Verge Of An Even Larger Breakout”. However, the bottom line is that the only effective way to stop inflation is either to dramatically increase investment in fossil fuels Where to aggressively crush the economy to reduce energy demand enough for the shortage to end before supplies run out.

The latter is, in my opinion, much more likely because, even if the government stimulates the energy sector, it would probably take more than a year before energy production increases to meet the high level of consumption of today. This result could be achieved by aggressive and QT interest rate hikes in a manner similar to Paul Volcker, but the Federal Reserve is still unsure whether to pursue this approach. Considering deliberately crushing the economy would probably be very futile politically, I think it’s more likely that the Federal Reserve will continue to adopt a “more dovish than necessary” approach.

Instead, looking at the energy and food markets, prices will rise so high that the economy will collapse on its own as people are forced to cut spending. Indeed, we are already seeing this trend today, as high prices have led to sharp declines in personal savings levels and significant increases in consumer credit. See below:

This data tells us that many Americans are now unable to save money and use credit to compensate. Of course, this situation cannot be sustained for long before people are forced to drastically reduce their spending. So the economy is see a decline in GDP and most other economic forecasts. Yet I don’t believe that these declines are not yet large enough to cause inflation due to the scale of the shortages.

Why “real” interest rates can peak

The central economic problem today is relatively simple, since 2020 there has been a sharp drop in the amount of things to buy, but no drop in demand for those goods and services, so prices are rising. Considering that the US government (and most foreign governments) has neither the power nor the will to force corporations to produce more goods and services, the only way to keep prices from rising is to lower the request. Many people are cutting savings and increasing credit card use to maintain consumption levels, but this cannot last long as prices will rise until consumption reaches supply.

So, in my view, either the Federal Reserve takes even more aggressive action to stop inflation, or consumer debt levels (and shortages) increase to such an extent that it’s literally impossible for many to buy certain goods. The latter, demand destruction, the alternative, is already in play, and as it picks up, should push inflation up a bit higher than the previous 8.3%. I believe this will be accompanied by another major spike in crude oil, gasoline and natural gas prices.

Once again, people will realize that inflation may not have peaked, the bond market’s rate of inflation expectation may break above its current plateau. It currently stands at around 2.6%, down from around 3% last month. Personally, I wouldn’t be surprised to see it reach the 4%+ level. However, given that the Federal Reserve is openly cautious about excessive rate hikes, I don’t expect bond yields to rise that quickly. In other words, I expect the inflation outlook to rise well beyond current medium-term interest rates, so “real interest rates” should fall, maybe back to the -1% level. If this happens, the TIP ETF (which tracks inflation-linked rates) may return to the $124-$130 range. See below:

Of course, if the bonds suffer significant losses, the TIP may struggle to rebound. However, as long as the economy slows down due to rising inflation (demand destruction) and not due to rising rates, the fundamental outlook for the TIP is strong.

The essential

In today’s stagflationary economy, investors looking to preserve capital would be wise to reduce their exposure to inflation and a slowing economy. Next to more speculative assets like crude oil (USO) and gold (GLD) futures, inflation-linked bonds such as TIP may be the best bet. I was somewhat cautious on the TIP at the end of last year as it looked like the end of QE would cause real interest rates to rise. We have now seen this play out, and given that the Federal Reserve has now made it clear that it will not be too aggressive in stopping inflation, real rates may be on the verge of falling again.

For investors interested in the TIP, it should be noted that its TTM dividend yield is a largely meaningless measure since its yield tracks CPI inflation and real rates. If the CPI inflation is 2%, the TIP provides about 2%. If the CPI inflation is 15%, the TIP generates about 15%. Of course, it also pays a small bond yield which is almost zero today. If this real return increases, then the TIP may decrease. However, for now, a decline in real yields seems more likely, which would benefit the price of the fund (but slightly decrease in performance). The ETF has a maturity of 7.7 years, so it closely tracks the rate of 10-year inflation-linked Treasury bonds. Overall, I’m moderately bullish on the fund and think it’s one of the last “safer” areas in the bond market for more risk-averse investors.