The Fed is making high risk speculation a very productive activity, with the liquidity backdrop they’ve provided to markets. In a world where Treasuries yield less than inflation, it actually makes sense to be indifferent towards price when investing in companies that can grow faster than inflation. This phenomenon is causing an excess of speculative activity in markets, which will end poorly for everyone.
First, let’s take a look at the data and assess what it means. For the first time in recent history, the interest rate on long term Treasuries (blue line), is below what the market believes inflation will be running at for the next five years (red line):
This is not a natural free-market phenomenon for the government to be able to issue debt at below the expected rate of inflation. This is the direct result of the Fed artificially keeping yields lower than what other market participants would demand. The Fed is doing this by purchasing 80B in Treasuries each month, irrespective of price. What the Fed is failing to understand are some of the knock-on effects of these actions.
Losing money in inflation adjusted terms for the opportunity to have the government to borrow your money is not an attractive proposition. It is only natural for investors to seek out higher yielding, riskier assets as an alternative to losing money to inflation. All of these risky assets are priced in relation to Treasuries: if I can own a stock that is trading at 50x earnings and can grow with inflation, this stock may be a rational investment if the Fed can guarantee treasuries will stay low for the foreseeable future. Since the Fed’s leadership has been placating markets with guarantees like this, it’s only natural for investors to bid up stock prices to levels that assume treasury yields will stay low forever.
The problem is the Fed is overpromising on its ability to control long term yields. The last time these two lines got close was in 2013, where a taper tantrum had bond yields shoot upwards shortly thereafter. I think we’re primed for an even larger leg upwards in bond yields in 2021 as the Fed will be forced to react to inflation above Fed targets. I’ve previously explained why I think oil prices will continue to rise. I believe this will cause 5 year inflation expectations to rise above 2.5%, a point at which the Fed will be forced to reduce bond purchases and let yields rise, to assure to markets that they aren’t losing control of inflation. Keeping yields low isn’t a Fed mandate, but keeping inflation under control is.
This will have a significant impact on markets. The levels stocks and other risky assets have been bid up to have made them extremely sensitive to changes in risk-free yields. The hypothetical stock I mentioned earlier, trading at 50x earnings, would have a risk premium over treasuries of about 3%. However, if longer dated risk-free rates rise to above 3% (something I think is likely in the near future), that same stock would have to trade at ~30x earnings to offer a similar risk premium. Another way to put it: it would have to lose ~40% of its value to still be attractive in relation to Treasuries.
The best way to protect against this is to bet on higher Treasury yields. TLT puts and shorting Treasury futures are attractive positions to hold as the Fed becomes forced to react to coming inflation.