Bonds (+ growth stocks)

A good demonstration of what’s happening within bonds, specifically looking at US treasuries (10 year yield) and 10 year TIPS (inflation protected bonds of the same maturity, the best proxy we have of the “real” risk free rate).

Firstly, inflation risk premia have risen. This is distinct from inflation compensation, which is the more familiar “amount investors require to preserve the purchasing power of their capital”.

The inflation risk premia reflects the uncertainty that investors have about their own inflation expectations (think of it as a wider variance around a mean for where inflation will wind up).

Secondly, term premia have risen. Term premia are the compensation investors demand for lending long, rather than rolling over a series of shorter dated bonds.

When we ask ourselves, why do risk free assets have an upwards sloping yield curve over time, as opposed to a flat one, or any other shape you could think of, the liquidity preference and preferred habit theories stack alongside the expectations hypothesis of term structures (EHTS).

The EHTS simply reflects the path of anticipated monetary policy, in the graph above the average of expected real short rate, and that is moving higher as the market anticipates tighter monetary policy.

We view higher term and inflation premia as entirely warranted, and at about the right levels.

The liquidity premia remain deeply depressed, and we suspect that as quantitative easing ends, this will move upwards, as a major buyer from the market is removed.

It is quite possible the LP moves back towards zero, which all else equal would push the US 10 year towards 3.5%.

For us, we would happily move overweight fixed income (currently +1% in our multi-asset portfolios) should that occur.

It is also likely that secular growth stocks would continue to decline, in that scenario, another factor we are well positioned for.

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