The Thing About Bond Yields and Interest Rates…

I wasn’t particularly sad to see last month come to an end. Volatility came back with a vengeance and bond yields rose to levels we haven’t seen in a long time.

But perhaps most interesting was the market’s welcome to incoming Fed Chair Jerome Powell. Powell gave an overall upbeat outlook for the U.S. economy… and stocks responded by selling off violently.

Go figure.

It seems that rather than be happy that the economy is healthy, Mr. Market instead fixated on the fact that, given the economy’s strength, the Fed would likely raise short-term interest rates four times this year rather than just three.

Now, frankly, I don’t think it matters much if the Fed raises interest rates 0.75% from today’s levels or 1%. I really don’t think that extra 0.25% is the proverbial straw that breaks the camel’s back. Another 0.25% isn’t likely the be the deciding factor for a company looking to expand production or hire (or fire) more workers.

Yet Powell’s comments sent the Dow down by more than 700 points in a matter of two days..

Even stranger is that longer term bond yields responded by rising.

I know what you’re probably thinking. Why shouldn’t bond yields be up? The Fed has effectively telegraphed that it intends to raise rates.

Well, yes. Sort of.

The Fed telegraphed that it intends to be fairly aggressive raising short-term rates this year. But, remember, raising the Fed funds rate is an anti-growth and anti-inflation maneuver. By raising rates, the Fed is intentionally trying to cool the economy to avoid an uptick in inflation.

Lower inflation expectations should cause bond yields to fall rather than rise. Yet here we are.

Markets often seem arbitrary and illogical, but they make more sense when you consider the human element.

The economist John Maynard Keynes compared the market to a peculiar kind of beauty contest in which the judges vote not for the girl they consider the prettiest but for the girl they expect the other judges will consider the prettiest.

I think that’s what we’re seeing today. Investors are selling bonds and pushing yields higher because they’re afraid other investors will sell bonds and send yields higher.

As a general rule, I consider it a bad move to try and play that game. Instead of trying to guess what your fellow investors will do, look for stocks or funds that are priced to deliver outsized returns. The market will eventually recognize that value and, in the meantime, you’ve collected a nice stream of dividends. That’s what we do in my income-based newsletter, Peak Income.

And, over the long haul, I expect we’ll sleep better and see better returns than the poor schmucks trying to outflank each other.

Our Peak Income portfolio has, by default, become a little more aggressive over the past month, as many of our more conservative bond funds got stopped out due to rising bond yields.

But that’s perfectly fine. We’re getting stopped out precisely because I’m being uber conservative and keeping our stops tight. We can – and likely will – jump back into a lot of these positions as pricing becomes more favorable.

I like collecting a high and growing stream of dividends. But I’m not willing to put my capital at excessive risk to make that happen.

I have a feeling that bond yields will level off soon. It’s entirely possible that we’ve already seen the high and that yields will drift lower. (In fact, I actually bet on exactly that in our sister publication, Boom & Bust.)

But if they don’t, and yields go higher first, that’s OK. We’ve preserved capital, so we’ll have plenty of buying power to snap up solid income opportunities on the cheap.