With a struggling bond market and persistent inflation, investors are turning to tangible assets like Gold

The bond market has been struggling for the last year-plus, with some analysts saying we’re in the early stages of a secular bear market. This has forced investors to reconsider the role of bonds in a balanced portfolio, with some pivoting to tangible assets with value – like gold.

Over the last couple of years, there has been persistent upward pressure on long-term bond yields. The 10-year Treasury spiked in 2022, rising from around 1.5 percent in late 2021 to a high of nearly 5 percent in the fall of 2023. Since then, yields have remained at those elevated levels despite the Fed cutting rates and geopolitical events that would have historically created significant safe-haven demand for Treasuries.

Reuters recently reported that “inflation, heavy government borrowing, policy uncertainty and bouts of stocks and bonds falling in tandem have weakened bonds' role as a ballast, prompting some investors to look for more diversification.”

Osaic chief market strategist Phil Blancato told Reuters that bonds only work as insurance in a portfolio when inflation is low. He said the wealth management firm has cut its fixed-income ratio from the traditional 40 percent to 31 percent with a 6 percent allocation to commodities.

Inflation certainly isn’t low. It has run well above the mythical 2 percent target for years. And while the CPI had cooled in recent months, the oil shock due to the U.S.-Iran war has restoked price inflation worries.

More significantly, the money supply has been on the rise for over a year, and despite the hawkish talk about slaying inflation once and for all, the Federal Reserve is currently expanding its balance sheet with a modest quantitative easing (QE) operation. This is inflation, by definition.

Last year, Morgan Stanley CIO Michael Wilson recommended an even more aggressive portfolio rebalancing, suggesting investors should cut their bond allocation to 20 percent and swap half of the bond portfolio to gold to serve as a “more resilient” inflation hedge.

"Gold is now the anti-fragile asset to own, rather than Treasuries. High-quality equities and gold are the best hedges.”

Northern Trust analyst Grant Johnsey told Reuters that bond returns are eroded over the long-term by persistent inflation, a weakening currency, and bond supply outpacing demand.

"Many investors are worried that one or more of these variables will play out in the coming years. The issue with the bonds is that when you go out past five years, there are too many potential downside headwinds and not enough tailwinds behind it."

Johnsey’s observation underscores the fact that it is crucial to consider “real interest” rates when evaluating investment options. Conventional wisdom holds that higher inflation necessitates tighter monetary policy from central banks, meaning higher interest rates. Higher rates are considered a headwind for gold because it is a non-yielding asset. However, even as nominal interest rates rise, inflation suppresses the real rate.

In simplest terms, the real interest rate is the stated rate you see on the news, adjusted for price inflation. To calculate the real interest rate, you take the quoted nominal rate and subtract CPI. This tells you how much your investment will yield in real purchasing power over time.

For example, the 10-year Treasury bond is currently yielding just over 4.6 percent. That seems like a pretty good return. However, the CPI is running at 3.5 percent. That means the real interest rate on a 10-year Treasury is only 1.1 percent (4.6-3.5=1.1). 

As the CPI increases, that real rate continues to fall.

Sagard Wealth Management CIO Stephen Harvey called the current economic environment “pro-growth and pro-inflation” and emphasized that fiscal policy now matters more than monetary policy.

In other words, investors are paying less attention to what the Fed and other central banks may do with interest rates and more attention to the rampant borrowing and spending by the world’s governments – particularly the U.S. Given America’s fiscal malfeasance, many investors have become reluctant to lend Uncle Sam more money. This is one of the primary drags on the bond market.

Harvey said Sagard is moving investors away from developed-market fixed income assets (bonds) and into a “preservation bucket” that includes commodities, gold, real estate and infrastructure. He called fixed income “the inflation loser.”

Central banks are also spurning Treasuries and upping their gold reserves. Earlier this year, the European Central Bank confirmed that gold has passed Treasuries to become the world’s top reserve asset.

Last year was the fourth-largest expansion of central bank gold reserves on record, at 863 tonnes. That was down 21 percent year-on-year, but still well above the 2010-2021 annual average of 473 tonnes.

The all-time high was set in 2022 (1,136 tonnes). It was the highest level of net purchases on record, dating back to 1950, including since the suspension of dollar convertibility into gold in 1971.

State Street global market strategist Jenn Bender told Reuters that "real assets, tangible assets valued for their intrinsic physical qualities," have gained appeal since the post-COVID inflation shock. She emphasized that the case continues to strengthen as "the bond outlook clouds and soaring equity markets appear vulnerable."

"The worry is that there is some downside risk in equities. Fixed income is not the place that people want ​to move their equity allocations over to. Basically, real assets is kind of where you end up."