Bonds During the Last High-Inflation Era
Past performance is more useful in predicting future results than the literature suggests.
If we follow the suggestion made last week, the recent and present course of monetary creation will lead to inflation at some indeterminate point in the future -- so it might be instructive to look at corporate and Treasury bond markets during the 1970s and early 1980s double-digit inflation era. For those of you who didn't live through that era, congratulations are offered. It was ugly. One of the Carter-era proposals was to cap wages and prices at 7% growth rates; my employer thought the 7% wage cap was a great idea but the 7% price cap was something that had leaked out of Lenin's Tomb.
First, a little factoid: The double-digit inflation period as measured by year-over-year change in the Consumer Price Index, marked with the heavy black line in the charts below, could be limited fairly to March 1979-October 1981. But inflation is a state of mind as much as it is a state of economics. The chronology is telling: Inflation had been considered such a problem by the late 1960s that Lyndon Johnson closed the gold window to the French and Richard Nixon imposed wage and price controls in August 1971. Commodity-linked events such as the 1972 Great Grain Robbery and, of course, the 1973 oil price spike came afterward. That higher oil prices are alleged as a cause of an already-extant problem tells us something about the state of economic literacy during the Leisure Suit era.
It is more interesting to extend the analysis backward and forward in time from the double-digit era to the takeoff point in December 1976 and the low of the first disinflation cycle in July 1983. We can overlay the trailing one-quarter returns for both Treasuries and corporate bond indices over a range of maturity segments.
Click to enlarge
Click to enlarge
One thing we can see here is just how long it took fixed-income investors to grasp the damage produced by rising inflation during the 1970s and, in reverse, just how long it took them to embrace falling inflation during the 1980s. Markets are supposed to look forward; failing that, they are supposed to arbitrage existing events. Fixed-income investors had a hard time reacting to the past. To be fair, many investors felt burned by jumping on the bond bandwagon too soon in 1980 only to have Paul Volcker, in his pre-Volcker Rule days, pull the rug out from under them by raising rates.
This policy uncertainty went a long way toward maintaining a higher cost of capital than would have existed otherwise. One of the largest determinants of the liquidity premium, or spread between long- and short-term interest rates, is interest rate volatility. Currency volatility is critical as well; foreign investors facing wide fluctuations in the dollar demand higher yield in recompense.
The net result of all of this was the US didn't escape the true costs of high inflation until the very end of the era. The great bull market didn't begin until August 1982, nearly a year after 10-Year Treasury yields peaked in September 1981.
The herky-jerky Volcker was replaced by the gradualist Greenspan who both raised and lowered short-term rates slowly until he started to believe his Maestro propaganda and left us with a string of disastrous bubbles. The next inflation may be greeted with a gradualist response at first. This will give you time to exit. Then whoever is in charge will channel their inner Genghis Khan and start slamming rates higher. Past performance is more useful in predicting future results than the literature suggests.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter