History is a valuable teacher, but sometimes even greater lessons can be learned from those who lived it.
As it becomes increasingly apparent that the extraordinary four decades of declining interest rates have given way to a new secular uptrend, we thought it instructive to touch base with two market veterans who were present at the birth of the previous long-term cycle to get their thoughts on where we might be headed.
Dan...
Washington’s continuing budget deficits will help fuel higher bond yields—and lower bond prices.
Mandel Ngan/AFP/Getty Images
History is a valuable teacher, but sometimes even greater lessons can be learned from those who lived it.
As it becomes increasingly apparent that the extraordinary four decades of declining interest rates have given way to a new secular uptrend, we thought it instructive to touch base with two market veterans who were present at the birth of the previous long-term cycle to get their thoughts on where we might be headed.
Dan Fuss, the veteran vice chairman of Loomis Sayles, has been called the Warren Buffett of bonds for his skill in picking individual securities, and at 89, is still several years junior to the legendary Berkshire Hathaway CEO.
Louise Yamada is the ageless market maven who can’t seem to fully retire after running the investment advisory bearing her name and previously heading the technical research group at Smith Barney, following her illustrious mentor, Alan Shaw.
Spoiler alert: These veterans are both cautious now, with a strong preference for short-term Treasury bills.
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Some might quibble that, after the benchmark 10-year Treasury note yield declined from 15% in 1981 (a level never matched in U.S. history, even in the Civil War) to under 1% in 2021 (below the nadir of the Great Depression of the 1930s), it’s no news that this unprecedented downward trend is over.
But secular changes are often evident only in retrospect. In a research note this past week from Strategas Research Partners’ technical and macro research team, Chris Verrone pointed out that Byron Wien, the longtime Wall Street strategist, had observed that the liftoff of the secular bull market in August 1982 wasn’t recognized until August 1985. Bond yields had reached their absolute peak of 15% in 1981, but it wasn’t until they had declined and rebounded to 14% in 1984, making a lower high, that it became fully apparent the secular trend to lower yields and higher asset prices was in train.
The succession of lower highs in bond yields was broken last year with the 10-year Treasury topping 4%, according to Yamada’s chart work. And while the benchmark yield has pulled back to 3.71%, that’s up from the recent lows touched in March following the failure of Silicon Valley Bank.
Reversals of multidecade cycles typically happen only once in a generation, or a career, Yamada observes. That was the case with the previous upswing in bond yields, which began in 1946, following the repression of Treasury borrowing costs to finance World War II, through the Great Inflation that topped in 1981.
The great postwar bull market in stocks also accompanied the secular rise in interest rates. That illustrates another lesson of history. Over the two-plus centuries of the U.S., long-term interest rates have oscillated around an average of 5%, Yamada’s work shows. It was no coincidence that the bull market topped out in the late 1960s, with the Dow Jones Industrial Average tantalizingly close to the 1000 mark, after the 10-year Treasury decisively topped the 5% level.
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Fuss sees bond yields now in a similar stage as the late 1960s. He observes similarities to the price pressures accompanying the Vietnam War buildup, which he says put the Federal Reserve in an untenable situation. That would ultimately be resolved by Fed Chairman Paul Volcker lifting interest rates toward 20% to crush inflation, at the cost of back-to-back recessions in 1980 and 1981-82.
A couple of years ago, Fuss recognized the generational change and urged his children and grandchildren to borrow long-term at historically low rates. One benefited from Grandpa’s advice by locking in a 2% mortgage, a rate we’re unlikely ever to see again.
For investors, too, both Fuss and Yamada suggest positioning for higher yields (and concomitantly lower bond prices) in the future. That is in no small part due to their concerns about Uncle Sam’s finances—both the amount of securities the government will have to sell to fund the continuing budget deficits and the need to attract buyers for all those bills, notes, and bonds.
Fuss recommends a mixed portfolio of equities and fixed income, with a tilt toward companies with a history of dividend increases that keep pace with inflation. While price increases are slowing, he doubts inflation will return to the Fed’s 2% target, and is more likely “stuck” around 3.5%-4%, or possibly higher.
On the bond side, he adds, the best income comes from shorter-term Treasuries that pay over 5%. Those able to do the credit analysis should look for securities trading at a discount for possible gains, consistent with Fuss’ longtime preference for bonds that can rise in price. Otherwise, he’d opt for a so-called ladder of Treasury securities over varying maturities to capture rising yields as they mature, albeit tilted toward the peak yield of 5.39% at six months.
Yamada also is sticking with Treasuries. She likes three- and six-month T-bills so that she has something coming due every month to reinvest.
For DYI investors, that strategy has become easy and free with most online brokers and at TreasuryDirect.gov. It provides yields over 5%, free of state and local income taxes, which can be worth the equivalent of an extra half-point or more of extra yield in high-tax states.
For a generation, it paid bond investors to think long-term. Through short-term cyclical fluctuations, bond prices nonetheless made successively higher lows and higher highs, the hallmark of bull markets. That trend has changed. For those agnostic about the future of yields, intermediate-term maturities historically have captured most of the return from long bonds with a fraction of the risk.
For stock investors, higher bond yields become a significant headwind when the 10-year Treasury crosses above 5%, Yamada’s work shows. That hasn’t been the case since before the 2008-09 financial crisis. But history shows it could happen again.
Write to Randall W. Forsyth at randall.forsyth@barrons.com