Welcome to Finance and Fury. In the last episode I went through the bond market and how inflation expectations being on the rise are having their effects, yield curves starting to steepen. So what will happen to other asset classes?

In this episode we will look at this question. If the trend of nominal yields continues, what will be the effects on different asset classes, cash, shares and gold?

  1. Before we get into that – quick recap that when talking about yields, it is the returns on bonds expressed as a percentage
    1. bond yields are inversely related to the bond prices. The lower the price, the higher the yield, and vice versa
    2. Bond yields have been declining since 1982 in a long-term trend – as they were nearing zero, could continue into the negative long term or reverse course – 10-year Treasury yields have fallen from 15.8% 40 years ago
    3. There are fears that due to the economic recovery plans for every nation being printing money for stimulus measures – that this could lead to an inflation outbreak – hence, this recently led to a rise in bond yields
    4. Happened in most countries – in the US the yield on 10-year bonds were 0.91% at the start of the year – in a matter of a two months they went to 1.49% then 1.61% before declining to 1.42%
    5. The Australian 10-year rate jumped to 1.93% and this spooked the share markets
  2. Also, important to understand the nature of money flows – and that is that different asset classes compete for your money, as well as institutional money
  3. That is where the yields on bonds (i.e. the returns) can affect other investments prices by competing for investors money – supply and demand – if more money flows into one asset class in the expectation of additional returns over another – that is additional demand – so if the supply stays the same, prices should naturally go up
    1. Bonds can be seen as a safe harbour – but if bond have a negative yield, people may hold cash for 0% interest rates or Gold instead – so currencies can move or the price of gold also move if people are selling bonds and reinvesting in another safe harbour
    2. When making an investment decision – there is always an opportunity cost – i.e. what you forego in not choosing the next best alternative – the opportunity cost of an asset is what you give up by owning it – so the OC for investing in shares could be the yield on a bond – which may be dependent on the risk or return profiles of an investor
  4. However – there has been an increase in the amount of money supply – increasing the amount of money that can flow – the increase in the money supply has been flowing into bonds initially through QE – this can then be used for the reinvestment into other assets – where the money flows could be based around incentives of returns
    1. This is part of the theory as to why QE can lift share prices as well – super funds or other institutional investors selling their bonds in the secondary market to CBs and then using their new found cash to repurchase other asset classes
    2. policymakers have distorted traditional free markets – the efficient allocation of scarce resources

To start looking at asset classes – Quickly go through the dollar, or cash in general

  1. No surprise to anyone that the real value of cash is generally declining – the additional supply of money naturally devalues cash in each domestic country depending on what is happening to the supply
  2. Between countries – There are a million things that can affect currency exchange rates – interest rates, net exports, but the big thing for the value of money that is relevant to this episode is specifically inflation –
    1. Cash is used as a Medium of exchange – exchange for goods, services, but also as savings or an investment – holding cash has an opportunity cost – it is actually rather costly to hold cash in real terms if inflation does materialise – imagine getting an interest return of 0.5% if inflation is 3% – negative yield on the money of -2.5% p.a.
    2. Central banks have essentially put a cap on interest rates for a number of years – in most countries they say that interest rates wont rise for 3 years – at the same time as rising inflation expectations means that there is an asymmetric risk to the downside in real interest returns
  3. All the new stimulus and associated dollar printing by the Fed and other CBs does not bode well for the cash’s future – The major thing with dollars is that they will lose their real value – this then in turn incentivises the disposal of this cash into alternative holding vehicles – why save money if you know it is going to lose value – better to buy something with it

Relationship between yields and gold

  1. The historical data does not confirm that there is any positive relationship between gold and the bond market – over some time periods there is a strong correlation in price movements, some other times there isn’t
    1. 1970s – the price of gold was rising and bond prices were falling while rates were increasing rapidly
    2. 1980s onwards – there has been a long upward trend in bond prices – with declining yields – through this period there was no relation to the changes in the price of the gold market – gold had a bear market in the 1980s and some of the 90s, then went through a bull market in the 2000s
    3. There have been times that a negative correlation between nominal bond yields and Gold can be measured in the short term – seen some measurements that it is currently -0.80% – fairly minimal
  2. This is all on the nominal level – however there is a stronger relationship between bonds and gold – that is on the real yields
    1. what really matters for gold are the real yield rates – not nominal yields – this is because high and accelerating inflation rates affect gold and bonds differently – this relationship can be seen over the past 20 years – where the price of gold moves in relation to the real yield on a 10 year bond
      1. From early 2000s – gold prices were rising, as real yields started to decline as inflation picked up
      2. By Jan 2013 – real yields had hit their bottom at -1% and hold had topped out at around $1,800 USD an ounce
  • Between then and Jan 2019, real yields started to rise and gold prices went down – until the start of Jan when real yields started to drop – going down to -1% again and gold topping $1,800 USD an ounce
  1. So there is a negative relationship with real yield rates on bonds – the nominal rates minus inflation
  2. From an understanding point of view – there is likely no one cause for this – but if both bonds and gold are seen as a safe harbour and inflation is materialising and the real yields on bonds are going down or are negative – then investors may simply be buying gold instead of bonds
  1. If inflation expectations continue to rise and nominal yields on bonds remain controlled by QE policy – Gold miners and gold may do well – especially if additional stimulus on steroids makes matters worse with real yields – or if nominal rates don’t go up due to QE keeping them low by buying – keeping prices artificially high compared to a market outcome – whilst at the same time seeing run away inflation
    1. In this scenario – real yields will drop and gold would likely go up – and miners lag behind in prices but also increase

Shares – effect of on the risk free assets (done in past episode)

  1. Historically – shares have done well when the economy is booming
    1. Logic behind this – When people are spending money and making more purchases within the economy, the companies selling the goods and services will receive higher earnings thanks to higher demand – this then increases their balance sheets and investors feel confident – they invest either off positive results or the expectation of these – then the price of the shares go up as more money flows into the market
  2. But how did risk assets such as shares do when rates are rising along with inflation expectations?
    1. That is where with a booming economy, inflation can also materialise
    2. But one of the best ways to beat inflation over the long term is to buy share
      1. If an investor owns bonds – they would ideally want to sell these and buy shares when the economy is doing well and inflation is present and rising
      2. With bonds – if they are non-inflationary linked – say you have a 10y bond issued at $100, but in 10 years you get $100 back in nominal terms, if inflation was 2.5% p.a. then the real value of that bond is around $78
  • So, if the real yield has been close to 0% over this time period as well – you have effectively lost money
  1. This is where the opportunity cost comes in – would you prefer to participate in the share market for positive returns or hold a safe harbour asset which may lose funds in real terms?
  1. However – if the economy were to slow with consumers purchasing less and corporate profits falling – this can turn into a declining share market – investors may try and time the market and prefer to now purchase bonds – seen as the safe asset and get the regular interest payments guaranteed by bonds
  1. This safety of an asset class can also affect valuation due to bonds being the RF asset
    1. When valuing equities – in the CAPM calculations – investors add the equity risk premium they seek to a risk-free rate to compute the expected rate of return
    2. In this calculation – the RFR is the 10-year bond yield – this is why long-term bond yields can matter to equities
    3. As theoretically – given that a bond yield is the risk-free rate, a higher bond yield can be bad for equities and vice versa – as the excess returns may not justify the excess returns
    4. As the 10y bond yields also reflect the growth and inflation mix in the economy – if these are on the rise it generally means the economy is growing
    5. Looking historically – There have been many occurrences real yields on bonds rising as well as returns on the share market – happened during 1997-99, 2004-06 and 2016-18
      1. However – what happened in 2000, 2008, end of 2018 – the markets went through corrections
    6. Look at the average weekly returns for the MSCI index since 2000
      1. If inflation is rising and real yields on bonds are rising – then the MSCI average weekly return is 1.2%
      2. If inflation is falling and the real yields are also falling – then returns have been negative 1.3%
      3. If they are neutral – with inflation not moving and real yields staying the sale – the returns have been 0.2%
      4. The important thing about this relationship – is that when inflation is rising – the share markets performance is positive across the board – however the degree of the positive returns seems related to the real yields on bonds
        1. If real yields are falling – then the positive returns are 0.7% – compared to 1.2% if real yields are either neutral or rising
        2. Also – if inflation is falling, then shares also perform negatively
      5. What can be inferred from this – is that rising inflation expectations can lead people to invest more into the market
        1. Everyone would have a different reason to invest – so to pinpoint one cause for a rising market is hard – could be due to not wanting to lose value of your cash in real terms, or to participate in an already rising market
        2. However – historical equity and bond performance has been better when yields are rising rather than falling, but especially when this occurs along with rising inflation expectations – which is what is occurring now
          1. when risk assets such as shares fall sharply – these have been mostly around fears of policy tightening or late in the economic cycle – both of which aren’t on the table at the moment based around what wall street are betting on
          2. Where could we be wrong – Higher real yields with declining inflation expectations would likely create lower performances in shares – so would an increase in real yields if it is driven by fears about the removal Central banking policies that are keeping rates low  – but this outcome is not likely at this stage

So in summary

  1. If inflation continues to rise – then the worse asset class to be in would be cash
  2. Both gold and the share market can do well when inflation is rising and real yields are staying the same
  3. Remember that real yields on bonds are rising – but they didn’t rise at the same pace at nominal rates
    1. But it doesn’t matter – historically, if real yields rise by any rate whilst inflation is also rising – both bonds and shares have a positive performance – shares by a greater rate
  4. However these metrics point towards a rising market – but what goes up can come down – this is where rising yields – if it spreads through corporate debts can lead to additional funding pressures on companies in the share market – many companies in the tech basket that aren’t profitable at this stage
  5. So investing in gold or shares can go well in this environment – but there are corrections on the way – so it is important to be invested appropriately in quality companies and diversified within and across asset classes

Thank you for listening to today’s episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/

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