The comment on stock/bond divergence concerned the past 12 years. I think the inverted yield curve is absolutely still an example of a 'greater fool' (need a better term) trade, in that a sizeable part of the market thinks yields are close to peaking, and the next concern will be recession. So we're buying the longer duration Treasuries and TIPS because there'll be a huge amount of upside if rates start falling again.secondopinion wrote: ↑Wed Nov 23, 2022 7:29 pmYou are right that ground would need to be covered, but that does not mean the long shot is doing so. In risk management, buying the put option implies insurance; we do not have it with treasuries. The reality is that controlling inflation is priced in but with a considerable tail risk that it will not. In some regards, the risk-return profile is more like selling a put option rather than buying one. Hence, the likelihoods are to be in favor of inflation being managed. One year or two years, inflation drops, recession, the business cycle starts over, and the prediction is met. If you do not think it will be managed, buy TIPS or something else.Logan Roy wrote: ↑Wed Nov 23, 2022 7:03 pmWell on the ins and outs of fed policy and taming inflation, historically, we haven't tamed high inflation with rates significantly below inflation – as they still are. We've needed a Volcker moment. But with debt where it is today, there may be a cap on rates significantly lower than it was in the early 80s, before damage to the financial system becomes a bigger issue than inflation.secondopinion wrote: ↑Wed Nov 23, 2022 5:36 pmCPI is just an index that changes over time. It is more likely to drop than increase; it is not a coin flip nor is the "random process" identically distributed at all times. Remember, it is mostly the market's actions that determines if the 10 year yield it will be reasonable in all honesty. Even the Fed has limited control on the currency (hence why they are trying to do something all this time with limited success).Logan Roy wrote: ↑Wed Nov 23, 2022 4:36 pmThe 10 year yield is 3.7%, and CPI is 7.7%. The market obviously expects inflation to fall, but the market's ability to forecast inflation may be no better than a monkey's. To avoid a loss of purchasing power, one needs inflation to fall a certain amount within a certain timeframe.secondopinion wrote: ↑Wed Nov 23, 2022 3:09 pm
Who says that Treasuries are at negative real yields? They pay a fixed amount of nominal yield; what that nominal yield means in reality is up to the market and Fed. If you mean TIPS, then yes, the purchase power is impaired when bought at a negative yield (but it is fixed in loss); but they are not that way right now. However, will gold fare better against negative-yielding TIPS, let alone the positive-yielding TIPS? I am neutral on the gold debate
Something is not a "greater fool asset" if no one can come up with a significantly better option at that time.
Treasuries have spent much of the past 12 years as "greater fool" (we need a better term) assets – as demand for Treasuries on extremely low yields has become a bet on Fed easing, and is likely still to be one. Treasury yields and stock market earnings yields diverged several years ago, and both imply quite different things about the economy, if we believe they're still being assessed on fundamentals.
The US had great business and low inflation; that is unusual by most metrics. However, international stocks suffered terribly in comparison (looking 2010-2021: https://www.portfoliovisualizer.com/bac ... ion3_3=100). Note the dollar appreciated as well (https://fred.stlouisfed.org/series/DTWEXBGS) Verdict: US stocks did unusually well and US bonds actually did well versus the rest of the world currencies. Explain how the fundamentals of stocks and bonds suggest a contradiction?
The realism here is that we can run into bad times for US bonds as a tail risk; the market is skewing the risk-return profile, however. As a result, the coin is not equally weighted, but which side do you want? "Greater fool" is hardly relevant here for stocks and treasuries; gold is also pricy. Everything seems pricy; so, what is the wise action?
Academics are divided on whether we're behind the curve. Having said that: this is essentially what buying an Option is. It's a bet on it being at a certain level by a certain date. And I don't think anyone would suggest the market (or any of us) know where inflation's going to be a year from now.
Stock and bond fundamentals diverged because stock market valuations implied very high future growth (e.g. buying stocks with <1% earnings yields assumes a lot of growth) while bond market valuations (buying bonds with 1% yields) implies a very high price on protection – i.e. securing a safe 1% over 10 years is a good deal. And the reason for this is that we know, so long as inflation doesn't show up, there's a 'Fed put'. So if the earnings growth isn't there, the Fed will become forced purchasers of bonds. And we've had that dynamic for about 40 years, which has allowed stocks and bond valuations to follow each other up.
The choice of fundamentals to show divergence are not quite right:
- First, they are far from this now.
- Second, were are no longer in COVID low yields with market highs (and to think 2018 had some yields).
- Third, the dollar has strengthened against other currencies.
And many countries use different techniques to control their currencies for the short- and long-term; it is one of their jobs of having a good currency. Bond buying/selling does this for the long-term.
And I think the basic principle of trading in this environment will be selling the rips on long duration assets, to buy ultra-short (as cash rates get better), and vice versa when long duration dips. And my model portfolio has 17-18% in gold, to get my overall dollar exposure in the 50% range. I've also added more global inflation-linked bonds. I wouldn't bet against the dollar, but I think there is a sensible balance.