'Flation Up, Bond Prices Down

How to invest when inflation and rates are rising...

SO WHAT'S happening in the financial markets? asks Nick O'Connor in Dan Denning's Capital & Conflict at MoneyWeek Research.

The first thing you need to understand is that rising inflation is bad for bonds.

If you own a bond yielding 1% when inflation is zero, you still make a real return of 1% a year. If inflation spikes to 3%, you make a loss of 2% a year.

That's what makes bonds an unattractive prospect when inflation is rising.

And remember, you need to think of the price of a bond and its yield as the two different ends of a seesaw. As the price of bonds goes up, the yield comes down. As the price goes down, the yield goes up.

With inflation expectations picking up across the world, people are selling bonds hand over fist. That selling pressure brings the price down and the bond yield up.

That's how we end up with both rising inflation expectations and rising rates. Which is exactly what we're seeing right now. As Ambrose Evans-Pritchard reported in The Telegraph:

"The moves [out of bonds] have been dramatic. The SPDR Dollar fund of US Treasuries with maturities over 10 years has crashed 6.39%. Its equivalent for the Eurozone is down 3.83%, and cumulatively down 9% over the last three months.

"J.P.Morgan's emerging market bond fund has dropped by 6%, and Pimco's local government variant is down 7%. Investors that gobbled up a AAA-rated 70-year bond issued by Austria in late October have already lost over 6% in paper terms."

It remains to be seen whether this is a trend that's going to keep running. It may fizzle out. It could certainly pause for breath. But it certainly feels like a new reality we're going to have to invest for.

For instance, Jeffrey Gundlach, a bond analyst who predicted a Trump win, believes yields on ten-year Treasuries could spike to 6% in the next four to five years, according to a Barron's report. Given yields hit a multi-decade low of close to 1.6% over the summer, that'd be a major move that would shake the foundations of the monetary system.

We'll look at what that would mean for the bond market – and government spending as a whole – another day. Today, let's stick to what you can do about it.

The first thing to keep in mind is that if you're an active investor looking to make money from the markets – and I'm going to assume you are – you need to acknowledge when the key trends reverse and act accordingly.

This is one such time.

For the last 30 years, bond yields have been falling. And for the last five, inflation has been doing the same. If both of those trends have now reversed, as all the signs indicate, you need to change with them.

It's not necessarily easy to do that. But the best part of my job is that I work with incredibly experienced financial experts who can help guide you with advice and insights you won't find anywhere else. People like Charlie Morris, Tim Price and Eoin Treacy. (By the way, next week we're holding our annual on-camera roundtable on what to do with your money next year, so look out for that.)

For instance, The Fleet Street Letter's Charlie Morris has been preparing his readers for this scenario for a while now. At our conference earlier in the year, he outlined a "money map" to help understand where you need to position your wealth.

Instead of geographic coordinates, the lines on this map chart the two trends we've been discussing: inflation and rates. Understand where they're going and you'll see where your money should be:

Here it is:
 

There are two ideas working in tandem here. One is what's happening in the world, the other is your response to it. It's a surprisingly elegant way of analysing the world and figuring out what to actually do with your money.

For most of the past three years, the world has been squarely in the bottom left quadrant: bond yields have been falling and so has inflation (the blue axes and red writing). That's an environment you'd expect quality stocks and fixed income to perform well.

But where are we going next? Charlie believes that bond yields are going to start rising (look to Japan for leadership) and inflation will pick up. That starts to move us towards the top right quadrant. If that's the case, he'd expect commodities and value to perform.

The key, though, as Charlie pointed out, is not to be in the wrong place. That means if the conditions are top right...you don't want to be bottom left.

And it's not necessarily a case of moving all your money into the corresponding quadrant. It's more how much of your portfolio you allocate. You want to have a high exposure to areas that are likely to outperform in the conditions and reduce exposure to areas likely to underperform.

Charlie has a variety of recommendations for each quadrant in The Fleet Street Letter portfolio. But he's concentrated more of his trades in the top right: commodities and value. If you want to know what they are – just take a trial of The Fleet Street Letter (you can review it for 30 days and get your money back if you don't like it).

This is the kind of idea that demonstrates how valuable it is to have Charlie on your side. He's great at combining macro analysis with specific and actionable investment advice. Which is of course the whole point of our business: understand what's happening in the world and use that understanding to help you protect and grow your money.