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Science vs. Speculation in Post Crisis Bond Markets
This post is obviously a bit anecdotal, but I’ve been thinking about three prominent predictions from the past few years and analyzing those predictions relative to what the market was forecasting and what academic research had to say. The three predictions were:
  1. Interest rates would increase so, you should stick to short-term bonds (if investing in bonds at all).
  2. The municipal market would experience significant trouble in 2011.
  3. Inflation would spike significantly.

Rates Would Increase

At the end of March 2009, the three-month Treasury bill was yielding about 0.21 percent, and the five-year Treasury note was yielding 1.68 percent (i.e., the good “ole” days). The difference in yield was therefore 1.47 percent. Certainly, both rates were well below historical norms, but academic research has shown that extending maturity — owning the five-year bond instead of the three-month bond — in such environments has generally produced a positive return. The conventional prediction of this era produced the exact opposite recommendation: stay in short-term bonds and wait for rates to go up. We can now see how these strategies fared.

Staying in three month Treasury bills from April 2009 through December 2012 produced a total return of 0.57 percent, meaning that if you started with a dollar invested you now have slightly less than $1.01 (not a typo). The five-year bond strategy produced a total return of 17.5 percent, meaning that a dollar turned into roughly $1.17. Keeping in mind that this is an anecdote, it nevertheless illustrates the power of applying science to investing.

Municipal Market Trouble in 2011

One prominent financial market analyst whose name rhymes with Leredith Litney predicted a massive wave of municipal market defaults in 2011. Looking back at the end of 2010, you see that municipal bond yields were lower than Treasury yields, hardly an indication that the market was ready to implode. Investors who accepted the market’s assessment at face value would have concluded that Leredith was likely wrong and invested in municipal bonds if that was appropriate for their tax circumstances.

Over the next two years, Vanguard’s Intermediate-Term Tax-Exempt Fund (VWITX) earned a total return of 15.9 percent while its Intermediate Government Bond Index Fund (VSIGX) earned 12.6 percent, a great showing for municipal bonds relative to other government bonds.

Inflation Will Spike

I’ve been hearing for years now that Federal Reserve stimulus would produce a massive spike in inflation. While the jury is ultimately still out on this one, so far we’ve had anything but high inflation. Toward the tail end of the financial crisis, the financial markets were projecting inflation to be about 2 percent per year for the next five years, hardly a forecast for extremely high inflation. From April 2009 through November 2012 (don’t have December’s data yet), inflation was 2.2 percent annualized, which isn’t that far from the market’s forecast.

We can all look back over the past decade or more and find instances where the market appears to have gotten things wrong, but we should never forget that markets generally do a really good job. We should also be skeptical of anyone’s ability to provide better forecasts than the market itself provides.

Random Links and Commentary of the Week

Here’s an extremely entertaining story from The New Yorker about professional pickpocket Apollo Robbins.

I’m a huge Peyton Manning fan — as a Tennessee Vols, fan he’s really all I’ve got to hold on to at this point — but for the life of me I can’t understand how he throws that pass in overtime. He’s on his side of the field, in sudden death and throwing a pass across his body running to his right. Nothing good ever comes from that. All in all, though, the Broncos had a great year, and I hope Peyton will get another shot at the Super Bowl next year.

Jared Kizer is the director of investment strategy for The BAM ALLIANCE. See our disclosures page for more information.

Comments

Anecdotes are OK

Hi, Jared.  I appreciate your caveat that these are anecdotes, but anecdotes that illustrate something that's been shown empirically are fine with me.  The unreliability of market-related forecasts has been proven, in my mind, beyond any doubt.  (See, for example, "The Signal and the Noise" by Nate Silver.")

Oh, and thanks for the link to the New Yorker piece!

-Neal Merbaum
at 1/17/2013 4:10 PM

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