We thought we’d look further into rising interest rates. As we pointed out, bond yields have been rising at their fastest rate in 25 years. The yield on the 10-year U.S. Treasury bond, is 60 percent above its December low.
Rising long-term interest rates go hand in hand with an expanding economy as demand for credit typically pushes yields higher. A number of consumer lending rates key off of the 10-year bond, which is why 30-year fixed mortgage rates have climbed back above 5 percent.
What’s different this time around is that rates have made a big move even as the economy is only showing just a few “green shoots” of improvement—far too few to pronounce a real turn in the economy. If the government is truly going to get the economy on an upward track again it will need to keep mortgage rates in check so as not to derail a recovery in the battered housing sector.
To do this, the Federal Reserve is resorting to so-called “quantitative easing,” effectively printing money to pay for the bonds. The Fed has already stated its intention to buy up to $300 billion in Treasury bonds, $200 billion in debt from government-sponsored enterprises (GSEs) and up to $1.25 trillion of mortgage-backed securities guaranteed by the GSEs and federal agencies this year. But if rates keep rising, the central bank will have to keep buying Treasurys and agency paper beyond those targets to artificially hold rates down.
While quantitative easing should help to stimulate the economy, and relieve troubled banks in the process, it will bring with it an unintended consequence: raging inflation. Since last September we’ve seen Federal Reserve Bank credit soar from around $890 million to more than $2 trillion. The additional bond purchases will only add to that staggering sum.
Putting that money into the system is one thing, wringing it out of the system later is quite another. In the tradeoff between fostering growth and fighting inflation, government officials and central bankers will opt for higher growth every time.
Already we’re seeing signs the bond market is signaling that inflation will return. Take a look at the graph below. It shows the performance disparity between a basket of longer dated Treasury bonds and Treasury Inflation Protected Securities, which are bonds that adjust the income stream with inflation. As you can see, garden variety bonds have lost considerable ground this year while the inflation protected bonds have advanced.
Owning inflation protected securities through an ETF, such as the Treasury Inflation Protected Securities ETF (TIP) or a mutual fund such as the Vanguard Inflation Protected Securities Fund (VIPSX) is a good idea. But all investors should also hold a fair portion of their assets in the ultimate inflation hedge: gold.
Gold is the forgotten asset class. The metal steadily lost value during the Great Moderation, the extended period of low variability of economic output and declining inflation that ensued after then Fed Chairman Paul Volcker raised interest rates to never-before-seen levels. And while gold has been the top performer during this decade it’s still decidedly undervalued. Adjusting for inflation, the yellow metal would have to rise above $2,500 just to match its 1980 monthly average peak. We think it will climb far above that mark in the coming years.
Our portfolios are peppered with gold via the SPDR Gold Shares (GLD) and gold stocks by way of the Market Vectors Gold Miners ETF (GDX) and a number of individual names ranging from blue chips, to mid-tier miners, to smaller, more aggressive players. Spread your risk by purchasing a number of these shares. Then sit back and wait, you’ll be well rewarded for your patience and foresight.
