Why are bond yields so low if inflation is so high?

00:00:00.000 | Welcome to Portfolio Rescue. This is our show where you, the viewer, determine our topics.

00:00:22.640 | We've got a special episode today. I am sitting in the same room as Duncan right now. It looks

00:00:27.480 | like we're on different screens, but we're here together. I flew all the way into New

00:00:29.680 | York just to see Duncan. We've got some special guests today, so this is going to be fun.

00:00:33.560 | Remember, if you have a question, email us at AskTheCompoundShow@gmail.com. Duncan, how's

00:00:37.760 | it going? I think Duncan was a little nervous today because there's a lot of moving parts.

00:00:42.120 | It's easier to do it over Zoom than it is in person, right, Duncan?

00:00:44.840 | Yeah, it's a little complicated being in the same room. If you hear some echo, that's what's

00:00:49.240 | going on.

00:00:50.240 | All right, all good. All right, let's do question number one.

00:00:54.280 | Okay, so first up, we have a question from Mike. Mike writes, "I believe I'm in a somewhat

00:01:00.560 | unique retirement position. As a career firefighter in South Carolina, after 25 years of service,

00:01:05.960 | my pension should end up being about 60% of my salary at retirement. I tend to ignore

00:01:10.280 | the fact that I'll have a pension and just try to invest for retirement the same as everyone

00:01:14.040 | else, a Roth IRA, wife's 403B, a bit of crypto sprinkled in for fun, etc. Should a future

00:01:21.280 | lifetime pension influence my investment strategy or risk tolerance? Would your strategies and

00:01:26.000 | tactics change if you had a lifetime pension waiting for you once you hit 50?"

00:01:30.520 | The good news here is that this guy has a pension. I did some research for my last book,

00:01:35.280 | Everything You Need to Know About Saving for Retirement, and I found in the early '80s,

00:01:38.440 | it was basically 60% of all workers had a pension in the United States. The number I

00:01:43.240 | found for today, it's closer to 17% and probably heading lower as people go into 401(k), so

00:01:47.640 | this is pretty good.

00:01:48.640 | I tried to put some value on it, so I reached out to Nick Magiulli, Nicky Numbers, our data

00:01:52.080 | guy here. "John, let's do a chart on ..." I tried to figure out the value of what this

00:01:55.720 | pension could be like. I did some values here, and you see this is the annual pension payout,

00:02:00.640 | so 25 to 100 grand I put per year, and I put it at different discount rates and tried to

00:02:04.640 | take the present value of those cash flows to today. You could see that could be worth

00:02:07.840 | hundreds of thousands of dollars, even millions of dollars for someone. This is a good problem

00:02:13.080 | to have.

00:02:14.080 | Let's talk about it. The way I look at this is this is not so much a investing question

00:02:19.500 | as it is a financial planning question, so I decided to bring in one of our financial

00:02:23.360 | advisors here who actually is based in New York, Alex Palumbo, one of our rockstar financial

00:02:26.960 | advisors who works this stuff on clients all the time. Let's bring him in, John. Alex,

00:02:32.680 | how's it going?

00:02:34.880 | Hello.

00:02:35.880 | So, you get a client that comes to you and they have some sort of income source. It could

00:02:39.320 | be a pension like this, which is, I think, a good problem to have. It's out there into

00:02:43.320 | the future. I'm sure people sometimes worry, "Is it going to be there for me?" But how

00:02:47.440 | do you think through something like this where someone's getting this steady income, and

00:02:51.120 | then how does that flow into how they plan their portfolio out?

00:02:55.920 | Right. I mean, theoretically, of course, you do not need to take on as much risk as an

00:03:00.840 | individual who's going to retire at 50 as someone with no pension. That's pretty obvious,

00:03:04.880 | right? To use an example, let's say that this is going to be worth $150,000 a year every

00:03:09.800 | year you're alive. Actuarial speaking, if you make it to 50, you should live till about

00:03:14.120 | age 85 or age 93 is the expectancy, which means that that pension is going to pay you

00:03:18.680 | out between $5 million to $6.5 million total, right? Assuming you'll cost a living adjustment

00:03:23.600 | too, which there could be. So, of course, you'll be able to achieve your family's financial

00:03:28.320 | goals more than that person who retires with a $2, or $3, or $4, or $5 million 401(k) balance,

00:03:35.480 | right?

00:03:36.480 | So, theoretically, you can, of course, take on less risk.

00:03:39.520 | A lot of people ask, "Should I view this pension as a bond and does that allow me to take more

00:03:44.040 | equity risk?" How do you think about that question?

00:03:46.280 | Right. So, the big elephant in the room, the Michael Batnick, however, is the fact that

00:03:51.080 | is a sequence of returns risk, which you wrote a blog post about this pretty recently. So,

00:03:54.920 | the counter argument is the fact that you will not need to live off as much of a percentage

00:04:00.540 | of your assets if you do have that pension coming in as someone who needs to only live

00:04:06.200 | off their 401(k), right? So, to assign numbers to it, let's say that you have a $2 million

00:04:13.200 | portfolio and you need to live off $100,000 from that. That's about a 5% burn. But let's

00:04:18.280 | say the market is down 50%. Now, you have $1 million and you need to live off $100,000.

00:04:24.600 | That's a 10% burn rate, which is way too high. Versus if the market is up 10%, now you have

00:04:30.000 | $2.2 million, then you're living off about a 4% rate.

00:04:32.760 | If you have this pension supplementing $80,000 per year, then you only have to live off of

00:04:37.520 | $20,000 per year. So, then your burn rate ranges from 0.9% to 2%, and both of those

00:04:42.920 | are extremely sustainable. So, the counterpoint to that is you need to live off less of your

00:04:46.760 | investable assets. So, theoretically, maybe you can take on more equity risk.

00:04:51.160 | Right. So, you might be able to take more equity risk. You might not have to, though,

00:04:56.200 | which is a good place to be. Yeah, that's the whole point, right.

00:04:59.960 | Do we say thank you to your service to firefighters? Is that okay?

00:05:03.440 | Yeah. I'm in New York, so let's do it. All right. Duncan, next question.

00:05:09.360 | Okay. So, up next we have the following. What are your thoughts on using an S-block security-based

00:05:16.800 | line of credit against a fairly large brokerage account, $250,000 to $300,000, to either borrow

00:05:22.120 | for a primary residence up to $150,000 or, say, $50,000 for a rental property down payment?

00:05:29.040 | This doesn't seem to be discussed very often anywhere except related to the extremely wealthy

00:05:32.660 | borrowing against their equity holdings. So, I wanted to get your feedback.

00:05:36.640 | There's definitely been some more of this lately. The Wall Street Journal had a piece

00:05:40.900 | on this this past summer, and they said that borrowing against your securities in your

00:05:45.360 | portfolio has grown from $30 billion in 2016 to nearly $70 billion as of this summer. So,

00:05:51.160 | people are definitely doing it. Obviously, the low rates has a lot to do with it. But,

00:05:54.080 | Alex, I'm sure this is a question you get from clients, and I'm trying to think through,

00:05:58.760 | what are the advantages of borrowing against your portfolio instead of taking out a loan

00:06:02.840 | from a bank?

00:06:03.840 | Yeah. You said the study was from this summer, where people are borrowing more?

00:06:07.640 | Yeah.

00:06:08.640 | Shocking, right? Now that the market's ripping higher. So, I agree that S-blocks are not

00:06:12.420 | discussed enough. I'm a huge fan of the convenient and rather simple process of placing a security

00:06:17.360 | back line of credit on your portfolio. They're free to set up. There's no cost in place unless

00:06:22.240 | it's actually tapped, and there's no underwriting necessary because they're collateralized by

00:06:27.400 | the securities in your portfolio. They're perfect for a client who wants to sell their

00:06:31.720 | primary residence to move into another home, but don't have the liquidity to afford a

00:06:36.440 | down payment. But even if they do, there's no point of using their cash supply or sell

00:06:40.180 | their securities when we can simply leverage the assets within their investment portfolio,

00:06:45.800 | borrow against it, use the borrow funds to pay for their new home. Then, once their old

00:06:50.640 | home is sold, they pay off their S-block balance, and you've now bought a new home without recognizing

00:06:55.480 | any capital gains or selling any funds from your portfolio and missing any time in the

00:06:59.560 | market, which, of course, tends to go up. And also the qualitative factors of you don't

00:07:04.440 | have to rush or feel bootstrapped that you won't have enough money for a new home or

00:07:08.040 | that you're missing time in the market.

00:07:09.560 | The point here would be, this is crazy. You're borrowing against your portfolio. Markets

00:07:14.680 | are at all-time highs. Interest rates are low right now. What happens if your portfolio

00:07:18.600 | gets crushed? Aren't you an idiot for borrowing against it? What's the downside here?

00:07:22.480 | Yeah, there's some pretty, I think, apparent downside that might not be, you know, considered

00:07:27.680 | by certain people given what the market's been doing this past year. But this specific

00:07:31.800 | person asked, what if I borrow 150 grand against a 250k portfolio? That's a 60% borrow rate.

00:07:38.240 | Depending on the portfolio, you can really only borrow like 70%. I mean, assuming it's

00:07:41.920 | invested in equity.

00:07:42.920 | Right. What do you think is like too high of a percentage that would make you feel uneasy?

00:07:48.000 | It really depends on the situation, but 60% definitely seems like I'd feel very uneasy,

00:07:52.640 | right? So what happens is a downturn in the market, the underlying collateralized securities

00:07:56.880 | value is heavily impacted, and then a maintenance goal could be issued. And now you're forced

00:08:01.200 | to sell securities at either an all-time low or an extremely low point. And that really

00:08:05.000 | defeats the whole purpose of the S-block, right, in keeping your portfolio intact.

00:08:08.680 | Well, those rates are really low right now, but they're not fixed. They're variable

00:08:12.640 | on the S-block. The interest is not tax deductible. So moral of the story is, I would make sure

00:08:17.160 | that you have an actual payment plan in mind and in place before you take the S-block.

00:08:23.400 | This person seems like they just want to have this S-block going in perpetuity with no repayment

00:08:27.640 | plan to just YOLO 60% of the portfolio. And that just doesn't really seem like it's

00:08:32.360 | prudent advice.

00:08:33.360 | And it makes sense why people want to do these. Wealthy people hate paying taxes, right? So

00:08:38.640 | this is a way to skirt taxes and borrow against it. And you feel like you're borrowing against

00:08:42.240 | yourself. It makes a lot of sense.

00:08:44.280 | And there's a lot of good reasons to do this, of course. But just think about, you

00:08:47.280 | know, 2000, 2009. If you were borrowing from tech stocks in your portfolio, the S&P, you're

00:08:52.280 | down 10% after 10 years, while you were paying that interest rate for 10 years. And now,

00:08:56.720 | so you're paying that interest, and now your portfolio is down in value. That's

00:09:00.160 | the risk.

00:09:01.160 | Perfect. Thank you, Alex.

00:09:03.080 | Thank you.

00:09:04.080 | Duncan, next question.

00:09:06.080 | Okay. So next up, this is a nice short and sweet one. In your opinion, do government

00:09:12.680 | yields still give any real signal in terms of future growth and inflation, or has it

00:09:17.440 | all been obscured by the bond buying by the Fed? Everyone's favorite topic, the Fed.

00:09:21.680 | Yes. All right, John, let's do a chart on here. This is one of my favorite charts of

00:09:26.240 | the year. So I've plotted out here the 10-year treasury rate versus the US inflation rate

00:09:30.240 | over the past five years. You can see most years, these things plot along pretty nicely.

00:09:35.440 | And they look like they're following each other pretty closely. Like, oh, that makes

00:09:38.080 | sense. Bond yields and inflation have a relationship. Now you have this huge alligator teeth, right?

00:09:43.320 | Inflation has spiked to over 6%. Bond yields are still at 1.4. They spiked a little bit.

00:09:48.160 | Now they're falling again.

00:09:50.840 | We're going to bring on one of my favorite macro people, who happened to be in New York.

00:09:54.800 | I'm using my time here to sort of use people. So Cullen Roche is here from Pragmatic Capitalism.

00:10:00.960 | Also has his own ETF. He has his own advisory shop. Cullen, what do you think?

00:10:07.480 | Do you think that all of this monetary policy is obscuring the signals that we can get from

00:10:12.800 | simple things like interest rates that people would use in the past to say, hey, if growth

00:10:16.600 | is rising, rates should be rising too. And if inflation is rising, rates should rise.

00:10:19.480 | Like, that makes sense on a textbook perspective. We're not getting that anymore. Why not?

00:10:24.160 | Yeah. This is hilarious, by the way, because people who fast forward this are going to

00:10:28.080 | see me and they're going to think, like, how did Alex get 20 years older and uglier? But

00:10:34.680 | so this is something that a question I get a lot because people think that the 30 year

00:10:40.320 | treasury or the treasury market in general is some sort of like totally free market.

00:10:44.640 | And really, the way that I like to explain, especially the Federal Reserve market, is

00:10:49.000 | that the Federal Reserve is essentially a manipulation of what would have otherwise

00:10:52.880 | been free banking. So, you know, the whole manipulation or not manipulation story is

00:10:57.360 | just kind of nonsense because the system is what it is. And the Federal Reserve, by being

00:11:01.960 | involved as the central bank around all of the public banks, is by definition a manipulation

00:11:08.020 | and they have to set an interest rate. And so the analogy that I like to use to think

00:11:11.880 | of all of this stuff is that think of the Fed as basically walking a dog and the long

00:11:17.480 | bond is basically the dog. The Fed is holding the leash and the leash where they hold it

00:11:23.600 | being the overnight rate is super tight. They have absolute control of that rate and how

00:11:28.920 | much it can move. They let the dog on the farther out end of the leash kind of wander

00:11:34.560 | at times, but the Fed still has pretty tight control over that dog for the most part to

00:11:39.800 | the extent that they want it to. They could theoretically rein that thing all the way

00:11:43.760 | in if they wanted to and have absolute control if they decided to. I mean, if they went out

00:11:47.600 | and they did QE on the 30 year and they said the 30 year bond, we're going to be a buyer

00:11:52.200 | of the 30 year bond at zero percent, the 30 year interest rate would collapse. So, you

00:11:59.120 | know, thinking of all of this in terms of the way the market exists now, the Fed kind

00:12:03.280 | of lets the bond market wander. But for the most part in today's environment, I think

00:12:07.240 | that what's happening is that the Fed's been really clear that the dog has kind of started

00:12:13.160 | to wander a little bit. You know, interest rates popped a little bit from the beginning

00:12:16.800 | of really when COVID happened, interest rates collapsed and then they kind of popped back

00:12:21.080 | up and they've kind of started to come back down. And a lot of that is the signaling from

00:12:25.040 | the Fed that they're pulling that leash and they're making it very clear, look, we're

00:12:29.880 | not going to let this dog get too far away from us. And so a lot of that is sort of based

00:12:34.840 | on the market signals that I think are becoming increasingly apparent that the Fed basically

00:12:40.940 | thinks inflation is not going to get out of control for a sustained period of time.

00:12:46.200 | So do you think that this is, I mean, obviously people say, well, the Fed's buying all these

00:12:49.640 | bonds that has to do with it. I also think there's a lot of people are still starved

00:12:54.040 | for yield and retirees want to de-risk their portfolios. And so money is still flowing

00:12:57.800 | into fixed income.

00:12:58.800 | It's actually thinking of it in terms of like the relative safe asset shortage in the global

00:13:04.240 | monetary system. The U.S. Treasury bond is still the safe asset. And so if there's a

00:13:09.520 | shortage of safe assets in the whole world, especially in a world where inflation is in

00:13:14.320 | some places much, much higher, the Treasury bond is still the super safe asset that a

00:13:19.040 | lot of people go to.

00:13:20.040 | Do you put any credence to the signal of, okay, inflation is way up here and bond rates

00:13:24.600 | are down here. Do you say, well, the bond market is obviously smarter than everyone

00:13:27.880 | else and the bond market is signaling that this inflation is not going to last? Like

00:13:31.080 | how much, how much do you put into that signal?

00:13:33.200 | Yeah, I don't love the, the whole bond market is smarter than everybody narrative. I tend

00:13:37.480 | to think it really is sort of a function. The Fed's trying to guess what future economic

00:13:41.660 | growth is going to look like. And so the Fed being at 0% basically is signaling that the

00:13:46.280 | Fed thinks future economic growth is unlikely to be that great in the long run. And so they're

00:13:52.320 | still trying to stimulate things to some degree. And so the fit, the bond market kind of just

00:13:58.040 | follows that in the, the low yields of the last like 20, 30 years to me is more a signal

00:14:03.200 | that economic growth has just been kind of low and stagnant. Not that, you know, it doesn't

00:14:08.000 | mean that the stock market can't go up in those environments. A lot of the times, in

00:14:11.680 | fact, when, when interest rates are really stable, the stock market does really well.

00:14:15.160 | So could that also mean that we're thinking this is a signal that we think this current

00:14:20.240 | burst of economic growth is probably not going to last, right? Like that it's going to go

00:14:23.960 | back to where it was at two to 3% or whatever, and it's not going to remain high.

00:14:27.480 | The most interesting outcome here is that as we kind of like navigate into 2022, you

00:14:31.960 | know, what are the likely scenarios here? And does the, does the bond market actually

00:14:35.560 | start to look pretty smart in the current environment? Because the big things that we're

00:14:39.880 | seeing as we head into 2022 are, you're going to start having a big peel off of fiscal policy

00:14:45.080 | and statistically, you're going to start seeing the data is going to be basically the opposite

00:14:50.880 | of what we had from COVID, which was this big base effect. You now have a top effect

00:14:55.440 | where the data spiked a ton, and now you're doing year over year comps on a higher comp,

00:15:01.400 | which means that the inflation data is likely to start moderating around the summertime

00:15:06.360 | purely based on statistics. And then you've got things like if the supply shortages and

00:15:11.400 | like, you know, the LA port starts to ease up, which is pretty likely and looking like

00:15:15.880 | it's already starting to happen, then you could get into 2022. Inflation starts to moderate.

00:15:21.280 | The bond market starts to look pretty smart. And then you have like an outlier situation

00:15:24.680 | where we'll, you know, we pumped all this money into the economy and things got really

00:15:28.760 | good, but what if you get some give back? And then the economy starts to kind of look.

00:15:31.960 | Which is essentially what happened in like World War II. You had this huge spike in inflation,

00:15:35.680 | rates didn't go anywhere, and inflation came back down. And I don't know, to me, for the

00:15:40.560 | government, that's almost best case scenario, because they inflate away some of the debt.

00:15:43.640 | Right? Isn't that the idea? Potentially? Yeah. I mean, inflating away the debt, I don't know

00:15:50.240 | if that's really their goal. I mean, it's a byproduct of what they're doing. I mean,

00:15:55.600 | to me, this was a lot like a war in the sense that the government kind of just threw the

00:16:00.800 | kitchen sink at it because we didn't know how bad this was going to get. I think it's

00:16:04.400 | easy to kind of look at it in retrospect and say, oh, we did too much. But at the time,

00:16:09.640 | you know, this looked like an atomic bomb hitting the economy.

00:16:12.600 | All right, Duncan, we got one more interest rate question for Cullen.

00:16:16.440 | Okay, so next up, we have Nicholas from Sweden, which is cool. So Nicholas wrote, "This market

00:16:23.640 | sure doesn't make much sense. I was wondering what your take is on treasury yields. Inflation

00:16:28.000 | is running high, money is being printed like never before, and the stock market is only

00:16:31.480 | going up. But still, the treasury yields have been falling. So what do you think will happen

00:16:35.800 | when the market goes down?"

00:16:37.320 | All right, John, let's do a chart on here. I just plotted out, going back to the 1960s,

00:16:42.120 | the 10-year treasury and 30-year mortgage bond. And I put the gray scales in there that

00:16:47.440 | shows the recession. Every time there's been a recession since then, interest rates have

00:16:51.080 | fallen on the 30-year mortgage, on the 10-year treasury, whatever you want to say. I don't

00:16:56.520 | see why that relationship would have to. I mean, you get this, the Fed lowers interest

00:17:00.200 | rates, right? So that happens because they're trying to stimulate the economy. Investors

00:17:03.560 | have this flight to safety. I don't see why either of those factors would go away. I guess

00:17:08.600 | it's just, do we keep getting a lower floor every time there's a recession?

00:17:13.240 | I mean, what's the alternative? You know, we kind of got a little blip of this in the

00:17:16.720 | last couple of weeks where treasury bonds jumped 5% or so in the last couple of weeks

00:17:22.320 | when the stock market started to kind of get jittery. And to me, there is no alternative

00:17:27.480 | in terms of the truly safe assets. I mean, Bitcoin's not the thing, and gold's not the

00:17:32.200 | thing.

00:17:33.200 | So, you know, so we have to get negative rates eventually, right? Like, isn't that...

00:17:38.400 | You know, I was talking to Nick Majulie the other night about this, and he asked me, he

00:17:42.720 | said, you know, gun to head, where do rates go, 5% or 0%? I was like, oh, two guns to

00:17:47.240 | my head. I'll put two guns to my head and bet you that it goes to 0%. I mean, to me,

00:17:54.320 | the fact that rates didn't rise that much in an environment where, you know, we literally

00:18:00.400 | printed $7 trillion of new debt, and the Fed was stimulating up the wazoo, and CPI is at

00:18:08.000 | 6%, and interest rates are still pretty low. If that doesn't make long-term interest rates

00:18:13.960 | rise, then, you know, it's starting to look like, well, what will? You know, outside of

00:18:18.560 | like the Jack Dorsey hyperinflation scenario, it's starting to look like, well, yeah, it

00:18:24.320 | seems like the demand for these things is so strong that the likelihood of going to

00:18:28.200 | zero is just so much higher than...

00:18:30.040 | I think it's possible in like 30 years from now, people are going to look back and say,

00:18:35.240 | how did that ever happen in the '70s and '80s, right? Like that period is going to, I think

00:18:39.840 | that's going to be the outlier. More than this period, if we have it between like 1%

00:18:44.000 | and 4% or something, or 3%, or whatever the ceiling is now. It's hard to, because people

00:18:49.880 | have always said, like, refinance your mortgage now, because mortgage rates are going nowhere

00:18:52.720 | but higher, and every time they go lower, right?

00:18:55.120 | I mean, people are so scarred by the '70s, especially like generations older than us.

00:19:01.560 | But it was such a unique situation. And it's kind of countered almost all of the big macro

00:19:08.200 | trends that are going on now where, you know, the demographics were totally different from

00:19:12.320 | the baby boomers in the '70s. The tech trends didn't really exist in the '70s. And so it's

00:19:18.280 | just like completely different in terms of its environment when compared to the '70s.

00:19:22.680 | All right. Someone in the comments here says that Cullen has very good hair. I take that

00:19:27.440 | as an affront, because I thought I had the best hair. Oh, Alex thinks he's got good hair

00:19:32.440 | too. All right.

00:19:33.440 | It looks like Cullen's picture also first, so I don't know what's going on with that.

00:19:36.920 | Okay, well, someone wanted to get a good shot of him. All right. Thank you, Cullen. Thank

00:19:40.880 | you, Alex.

00:19:41.880 | I turned myself off for the sake of these guys.

00:19:42.880 | For coming in. Duncan, how did we do? First time live.

00:19:45.720 | It was good. Yeah, it was an experience.

00:19:47.760 | All right. We'll do a post-mortem after this and see what happened. Remember, if you have

00:19:53.560 | a question for us, it's AskTheCompoundShow@gmail.com. Next week, I'll be back in my office in Michigan.

00:20:00.160 | Duncan will be in New York still. Thanks, everyone, for watching. And thanks to Cullen

00:20:04.240 | and Alex for coming on board. See you next week.

00:20:06.240 | [Music]

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