The End of Speculation #1:

The pain inflicted on high quality, long duration bonds

Between March 2020 and December 2021, the US produced about $8 trillion in stimulus to economically battle the pandemic. Roughly half of that came in the form of monetary stimulus from the Fed and half came from fiscal stimulus via stimulus checks and loan programs. Deposits in the US banking system grew $4 trillion and money supply as measured by M2 grew by +40% over two years. The surge in money supply has caused a surge in inflation and rising bond yields…but it’s the rise in bond yields that has resulted in the end of speculation across major asset classes. Today we’ll discuss the End of Speculation #1: the pain inflicted on high quality, long duration bonds (an asset class and area we have long steered clear of).

In August 2021, the US Treasury issued newly minted 30y UST bonds. These new bonds had a 2% coupon and will mature in 2051. These new bonds were gobbled up quickly by the market and bond speculators – they wanted to buy them before the Fed did. A year ago, the Fed was doing quantitative easing to the tune of about $40 billion a month (roughly buying 50% of newly issued Treasuries and mortgage-backed securities). Bond speculators were attempting to “front run” the Fed by buying first. The chart below captures the historical price of those bonds. Between August 2021 (when issued at 100) and December 2021 (when inflation started) those new bonds traded between 100 and 108. All was fine for the speculators…until inflation set in, and bond yields rose. In August 2021 30y UST bond yields were 2%; today they are 3.1%. Not a huge rise in yields but higher. But when you own a 30y bond you own a lot of “duration” – that’s how sensitive a bond is to changes in yields. The lower the bond’s coupon and the longer the bond’s maturity, the higher the bond’s duration….and these August 2021 new issue 30Y had a TON of duration. 30y UST yields have gone up just 1.1% but the price of these bonds has fallen to 78, or down -28% from its price highs of early December 2021.

Eliminating bad, speculative behavior is a healthy thing. Investing is one thing and gambling is another. We invest. Higher yields are extinguishing speculative behavior in various asset classes, including what many considered to be “hedges” to market swings, such as long duration US Treasuries. These long duration assets won’t default but they have little chance to keep up with inflation. That will translate into a permanent loss in purchasing power over time. Much has changed over the past 6 months, but one thing is for certain: the end of speculation is here, and one casualty is high quality, long duration fixed income bonds.

Richard Barrett
Chief Investment Officer

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