“The inflation number is a reminder that Americans’ budgets are being stretched in ways that create real stress at the kitchen table.”
–President Biden
U.S. 10-year Treasury yields rose on Feb. 10 above 2% for the first time since August 2019. The increase was a result of the U.S. economy adding 467,000 jobs in January and inflation hitting a near 40-year high of 7.5%. Price increases were most pronounced in food, electricity and shelter.
This level of inflation indicates that the financial markets recognize that our economy is recovering from the pandemic and that the Federal Reserve will ratchet up rates.
Market analysts think that a 50-basis point hike in March is probable because our central bank has not raised interest rates enough to stifle inflation.
We could see a series of interest-rate increases. James Bullard, president of the St. Louis Federal Reserve, said he “would like to see rates up 1% by July 1.” He added that he “was already more hawkish, but I have pulled up dramatically what I think the committee should do.”
Peter Langas, chief portfolio strategist at Bessemer Trust, said, “The question is: Does the Fed get it right? Do they walk the line properly between raising rates and tightening policy at a pace that helps to curb inflation but doesn’t slow demand and hurt the economy?”
Why should we care about the level of bond yields? Investors focus on Treasury yields because they set a floor on interest rates across the economy that:
1. Establishes the cost of money, which is a key input in financial models used to value stocks, real estate and other investments.
2. The bond market is the source of money that determines trends in markets such as commodities, foreign exchange and equities. In terms of turnover, bond markets are 35-50 times bigger than equity markets.
Rising interest rates have impacted the stock market. In January, investors dumped shares of high-growth technology stocks for stodgier businesses, such as banks, oil companies and telecoms, that pay dividends.
Investors believe that income-generating stocks provide a safer harbor. By contrast, once high-flying stocks, including the largest tech shares, have performed poorly. The Nasdaq Composite suffered its worst January in more than a decade.
Sandy Villere, a portfolio manager at wealth management firm Villere & Co, said, “In this environment, a good place to hide would be some of these dividend-oriented companies that are going to grind through this market turbulence.”
Can investors get higher returns on equities given that the average dividend on the S&P 500 pays 1.3%?
Investors can participate in higher yielding equities by investing in exchange-traded funds such as Vanguard High Dividend Yield (VYM) 2.74%, Utilities Select Sector Fund (XLU) 2.91% or Schwab U.S. Dividend Equity (SCHD) 2.83%.
Don Ames, president of Ames Capital Management, recommends selling covered calls. The purpose is to enhance the income component of S&P firms with a history of paying and raising their dividends. For example, Ames purchased Chevron (CVX) at $137.50 and sold April calls for $2.50 per contract. If the trade is successful, Ames will make 8.31% in two months including receipt of CVX’s $1.42 quarterly dividend on March 10.
There is tension between the desire of our government to keep interest rates low on our $30 trillion federal deficit and the investment objective of bond investors such as Warren Buffett.
With interest rates so low, the real return on bonds is currently negative. In his most recent letter to investors, Buffett bemoaned fixed income as an investment saying, “Bonds are not the place to be these days.”
I heartily agree with Buffett. A 2% 10-Year Treasury when inflation is running at 7.5% does not light my fire. Inflation is the archenemy of every investor!
Originally published in the Sarasota Herald-Tribune