The Federal Reserve is starting to break stuff in its quest to tame inflation.  For example, real estate prices are teetering between stagnation and decline.  Segments of the labor market, particularly big tech, are cutting costs and increasing layoffs.

And perhaps most striking, three large banks failed this month.  Some key statistics show just how unusual the breakage was:

• Silicon Valley Bank (SVB) was the 18th largest bank in the U.S. and the 2nd largest bank failure ever.
• Signature Bank was the 36th largest bank in the U.S. and the 3rd largest failure ever.
• Silvergate Bank had nearly $12 billion in assets, placing it outside the ranks of the top hundred U.S. banks, but it was more than big enough to stoke anxieties.

The causes of these bank failures are all slightly different.  But one common thread seems to be large holdings of anemic-yielding “safe” Treasury bonds and securities that lost billions in value as the Fed raised interest rates and bond prices declined.  For example, long-dated Treasuries represented 55% of SVB’s assets.

Another common thread seems to be heavy concentrations of deposits and lending in the relatively risky areas of the tech sector and crypto companies like the failed FTX.  The money sloshing around in the tech sector for so many years due to historic, rock-bottom interest rates started to dry up with rising interest rates.  This spurred increased withdrawals from cash-strapped tech firms, which ballooned into panic withdrawals as rumors spread about each bank’s health.

Many have been quick to point out that this is not the start of another 2008-style financial crisis for various plausible reasons.  Nonetheless, flocks of regional banks suffered steep stock price declines in one day on March 13 as the fear of contagion spread including:

• First Republic – down 62%
• PacWest Bancorp – down 45%
• Western Alliance Bancorp – down 47%
• Zions Bancorporation – down 26%
• KeyCorp – down 27%.

The SPDR exchange-traded fund (ETF) for a large basket of regional banks (KRE) was down nearly 29% over the last two weeks and has yet to recover as I write this.  I don’t know the stories behind all of these banks, but it seems like the basic math of rising interest rates driving bond losses will continue to “stress test” many regional banks.  And bank borrowing at the Fed’s Discount Window went from $5 billion last Wednesday to $153 billion, the highest level on record.  It seems extremely premature for anyone to sound the all-clear.

Interestingly, higher capital requirements for “mid-sized” banks, like SVB and Signature, from the Dodd-Frank law of 2010 were rolled back in 2018 on a bipartisan basis and signed by Trump in 2018.  Some pro-bank observers claim the specific capital requirements and stress testing levels in question, if they still existed, wouldn’t have stopped the SVB collapse.¹  Many anti-bank observers actually agree.  They point instead to a multi-decade trajectory of increasingly lax and chummy bank regulation by the Fed and Congress.  For example, SVB CEO, Gregory Becker was on the board of the San Francisco Fed up until the day that his bank collapsed.  In this case, the regulator was the bad actor, all in one.

In retrospect, it seems stunningly obvious that rising interest rates would hurt banks with huge bond portfolios.  And yet, I’ve only seen one prediction of this particular breakage, which was in October 2022 by Douglas Diamond, who won the Nobel prize for his work on bank runs.  The recently failed banks clearly made inadequate preparations for the predictable losses, except for selling personal stock holdings and handing out last-minute bonuses.  Similarly, the Fed or Treasury could have evaluated the effect of higher interest rates on the banks they ostensibly regulate, but they failed to do so.

More Pain On The Way

And the Fed seems to have no intention of ending interest rate hikes soon.  The head of the Federal Reserve, Jerome Powell, said less than two weeks ago in Senate hearings that the Fed’s goal is, for all practical purposes, a recession of unknown length and duration.  Specifically, note these two phrases, when put side by side:

“…we understand that our actions affect communities, families, and businesses across the country…the process of getting inflation back down to 2 percent has a long way to go and is likely to be bumpy.“

I’m sure the Fed desires a level of “affect” and “bumpiness” that falls short of an outright recession.  But at the same time, Powell pointed out, “Our monetary policy tools are famously powerful, but blunt.”  Taken altogether, this sure sounds like a recipe for more economic breakage.

The Fed is trying to drive inflation back down to around 2% because high inflation is harmful in many ways.  And although there have been signs of “disinflation”, as the Fed likes to call it, recent decreases in the inflation rate have been gradual and erratic.

Read more

It may seem like I’ve been obsessed with inflation recently.  But so has everyone else, and it’s an important issue for long-term investors for reasons I’ve previously detailed.  So, it’s worth noting that the Bureau of Labor Statistics (BLS) recently issued its August Consumer Price Index (CPI) inflation data.

Here’s a typical headline about the new data from the venerable New York Times:

• “Price Pressures Remain Stubbornly High”.

And the fear of stubbornly high inflation caused the S&P 500 to slump 4.3% on September 14th, the day after the August inflation data came out.  This headline from Yahoo! sums it up:

• “Stocks Tank After Higher-Than-Expected CPI Report”.

On the surface, both of these headlines are accurate, but they miss a big part of the story.  The best analogy I can think of would be a story where a fireman bravely saves several children from a roaring house fire.  Yet the next day the local headline reads, “Fireman Stubs Toe During Alarm Call”.  In other words, there is some good news contained in the most recent inflation numbers.

Inflation Is Falling, Not Rising

In a July post, I noted that each month’s new headline inflation number adds the most recent month’s inflation data to the prior 11 months of data to create an annual inflation number.¹  That is, the August headline inflation value of 8.3% represents the overall inflation observed from September 2021 through August 2022.  But only the most recent month’s value represents anything new.  We’ve known the bulk of what’s contributing to the August 8.3% inflation value for many months.

When I’m looking for recent trends in inflation data, I find it much more helpful to focus on month-by-month inflation data.  Here’s a graph showing the 1-month change in inflation over the past couple of years.

The monthly data paint a different picture.  The 1-month change in CPI in August of 0.1% was the lowest reading over the last 22 months, with the only exception being the most recent July number.  In other words, the last two months strongly suggest that inflation is abating dramatically from June’s extremely high number of 1.3%.²

Of course, two months of data don’t constitute a long-term trend.  Inflation could spike again next month; no one knows for sure.  But to imply that the recent inflation numbers are adding inflation pressure is misleading.  The only way that the August 12-month inflation value of 8.3% could be substantially lower was if significant deflation had occurred in August, which means that prices would have to be decreasing in multiple categories of goods and services.

So Why Are The Headlines So Bad?

The reason for the dismal inflation headlines is summed up in a brief article from CNN.  Among other things, the article points out that:

• “The [index] rose 0.1% from July, versus economists’ projections of a 0.1% drop.” (my emphasis added)

In other words, everyone was hoping that there would be 0.1% monthly deflation, but we got that amount of inflation instead.

However, the BLS reports its margin of error as 0.06% on these monthly changes.  So, the August number could be as low as 0.04%, which becomes zero if we round to the significant digits that BLS reports.  And given that the August projections were attempts at predicting the future, they likely carry with them a much higher margin of error.  Based on my 35 years of experience with both projections and data analysis, I would argue that there is likely no statistical difference between the August projection and the actual result reported by BLS.

Read more

Treasury Inflation-Protected Securities (TIPS) are one of the few assets that offer a reliable hedge against inflation.  TIPS are a form of U.S. Treasury Bonds that are indexed to inflation.  So, when inflation rises, the government raises TIPS prices by a proportionate amount to compensate.

Years of finance research have shown that almost all other assets (like stocks, bonds, cash, real estate, and gold) are remarkably inconsistent and weak hedges against rising inflation.  One study by Bekaert and Wang in 2010 went so far as to say:

• “In short, it is next to impossible to use an individual asset or a portfolio of assets to adequately hedge inflation risk.”

Despite this conclusion, Bekaert and Wang were able to rank the limited inflation-hedging capacity of assets from worst to best as follows:

• Stocks
• Conventional Treasury Bonds
• Treasury Bills
• Foreign government bonds
• Real estate
• Gold.

This is why the built-in inflation protection of TIPS is extremely attractive for investors who are worried about potential future surges in inflation.

However, TIPS have only been around since 1997.  And in that time, Portfolio Visualizer data indicate that annual inflation has averaged a historically mild 2.3% with a peak of just 3.4% in 2005, excluding last year’s unexpected jump to 7.0%.  In contrast, during the prior 25 years, annual inflation averaged 5.6% with a peak of 13.3% in 1979.  It seems that the government invented TIPS just in time for obsolescence.  So, last year represents the first opportunity in history to see how TIPS perform when inflation rises substantially.

Further, last year’s inflation spike was initially dismissed as “transitory” and the persistence of high inflation into 2022 was a surprise to both investors and the conventional Treasury bond markets, which reflect investor expectations about future inflation.  Consequently, last year was particularly auspicious for the automatic inflation protection offered by TIPS exactly because no one was expecting a large and persistent rise in inflation.

So, in today’s post, I want to examine how TIPS, the only clear inflation hedge available, performed in 2021 as compared to other common asset classes.

Last Year’s Story

This graph shows the nominal (not inflation-adjusted) total 2021 returns of 14 asset classes from Portfolio Visualizer as compared to the 7% rate of inflation shown by the black horizontal line.  Types of stocks are shown in blue, types of bonds are shown in orange, and alternative assets of real estate (proxied by REIT stocks) and gold are shown in green.

Focusing on bonds for a moment, TIPS¹ were indeed the outstanding bond performer for 2021, with a nominal return of 5.6%.  All other types of bonds lost nominal money last year.  However, TIPS surprisingly lost inflation-adjusted money because their nominal returns were about 1.4% below the annual rate of inflation.  In my view, it’s pretty disappointing to lose inflation-adjusted money from an asset that includes an explicit inflation adjustment.

Read more

In my last post, I wrote about the recent spike in inflation, which seems to be mostly caused by shocks to the economy from the pandemic.  The Consumer Price Index (CPI) is currently indicating a relatively high annual inflation rate of 5.4% between September 2020 and September 2021.  However, last time I also presented evidence suggesting that inflation will likely recede within a year or so back to its previous level of around 2%.

The problem is that there is no sure way to predict the future.  So, in today’s post, I want to further consider what might happen to investors if high inflation lingers for several more years.  Specifically, I’ll focus on how rising inflation impacts retirement savers, those nearing retirement, and current retirees.

The reason that inflation is important to retirement investing, and other long-term investing ventures, is that most investing plans assume a rate of inflation for:

1.  Determining when it’s safe to retire.
2.  Setting retirement savings withdrawal rates to maintain an accustomed quality of life.

Let’s look at each situation separately.

Inflation When Saving For Retirement

As an example, let’s say you’re planning to retire 10 years from now and hope to live off of about 80% of the current U.S. household median income¹, which equates to $50,000.

But that retirement spending will take place 10 years from now.  And as inflation continues over those 10 years, that $50K will have less purchasing power than it does now.  So, we have to “inflation adjust” the $50K of expected spending to reflect future economic conditions.

The higher the rate of inflation over the next 10 years, the more you will have to save and/or the better your investments will have to perform to meet your retirement spending target (or expected “retirement income”).  This graph shows how much your inflation-adjusted retirement income will need to change depending on various levels of inflation rates over the next 10 years.

If the current inflation of 5% continues for the next 10 years, your inflation-adjusted spending target at the start of retirement would be nearly $78,000 to maintain the quality of life you experience today with an income of $50,000.  And even if inflation quickly returns to 2%, you’re still looking at an inflation-adjusted spending target of about $60,000 for a retirement that starts 10 years from now.

I should note that the worst 10-year annualized inflation rate in history going back to 1871² was 8.7%, which occurred during the highly unusual stagflation conditions of the 1970s and early 1980s.  Even a sustained decade-long inflation rate of 5% is pretty unusual as this graph of past decades from Inflation Data shows.

So, although the 8% and 9% inflation-adjusted spending targets look pretty scary, they aren’t that likely to occur.

Inflation Once Retired

Maybe you’re mostly past the saving phase and you’re already retired or expect to retire soon.  For this situation, let’s look at two examples that maintain an annual inflation-adjusted retirement spending target of $60K and $78K, respectively³.  Let’s further assume that you’re a mindful investor and you maintain an investment portfolio comprised mostly of low-cost stock index funds.  Finally, let’s assume you want to retire early and expect to have a 40-year retirement.

Read more

I’ve always said that there’s little reason to track the economy and markets closely because mindful investors don’t get too concerned about the routine gyrations of the markets.  Over the long term, the primary asset classes of bonds, and particularly stocks, have a good, although not perfect, history of positive returns.

For example, despite the scary reputation of stocks, historical data going back to 1928 suggest that there’s only about a 10% chance of losing inflation-adjusted money in stocks over 10 years.  And stocks have never lost inflation-adjusted money over any 18 years in history.

So, I wouldn’t blame you if you were unaware of the news about recent increases in inflation and concerns that it might hurt investors.  If you need a primer on inflation, this Mindfully Investing article provides some of the basics.

Inflation on The Rise

While I still believe that hawk-eyed economy watching is for the birds, I’m nonetheless intrigued by the recent inflation surge as shown in this long-term chart from Advisor Perspectives, which also shows the yield on the 10-Year Treasury bond and Federal Funds interest Rate (the base interest rate that the Fed offers to banks).

The green shading shows the annualized inflation rate as measured by the Consumer Price Index (CPI), which most recently registered 5.4%

It’s hard to see in the graph, but the last time that inflation hit this level was during the Great Financial Crisis in 2008.  Before that, you have to go back to 1990 to find a similarly high spike in inflation.  And sustained inflation of this magnitude hasn’t occurred since the early 1980s.  The recent inflation spike is even more remarkable considering that inflation hasn’t been this far above bond yields (blue line in the graph) and base interest rates (red line) since the mid-1970s when runaway inflation occurred.

What’s Happening?

The most obvious cause of the recent inflation spike is the recovery from the pandemic.  I’ve read lots of articles and analyses picking apart exactly why the pandemic has spurred inflation.  But the basic reason is the increased demand caused by consumers getting back to normal life, which has resulted in supply-chain and employment shocks that are still working their way out of the system for all sorts of goods and services.  When demand is high and goods and workers are scarce, prices go up.

How Long Will It Last?

It’s always difficult to predict the future, but most economists seem to think that inflation will subside quickly, similar to what happened in 2008¹.  Some inflation watchers are even making the case that the peak has already passed.  This makes sense because businesses have strong profit incentives to quickly solve the supply chain and employment problems to meet demand.  The most pessimistic expectations are that inflation above 2% could persist into 2023.  On the other hand, if businesses offer higher salaries to attract workers and consumers start to expect higher prices, those effects could sustain high inflation for a while longer.

Should Investors Care?

From a long-term (decades) perspective, we’ve already seen why stock and bond investors probably shouldn’t worry greatly about short-term variations in inflation.  On the other hand, several years of lingering high inflation could have noticeable repercussions for investors.

Consider that inflation is relevant to investing in at least two important ways:

• Economic conditions associated with high inflation can depress nominal asset returns.
• Increased inflation reduces the spending power of your invested money, which is the key reason people refer to “inflation-adjusted” returns.

Let’s take a closer look at each of these issues.

Nominal Asset Returns

I’ve previously explored the relationship between inflation and trends in asset returns.  Although the data are very noisy, it turns out that most asset classes have a negative or weakly sporadic correlation with inflation.  In other words, when inflation rises, the nominal returns of most assets tend to decrease or barely increase.  The asset with the best track record for “hedging” against inflation appears to be gold, although I’ve seen articles that debate this point².

Read more