By: Tim Hayes Financial Advisor - posted in: Investment Advisor - Last updated Feb 20, 2019

Don’t Fear the Bond Reaper

by | Investment Advisor

 “All our times have come / Here, but now they’re gone / Seasons don’t fear the reaper”

                                                      — Blue Oyster Cult

Over the past few years, some well-known economists have been alarming investors with their predictions that the Federal Reserve’s quantitative easing (QE) program fuels inflation. If inflation does heats up, interest rates will rise, and investors who own both stocks and bonds will see the value of their bonds fall. However, contrary to these predictions, inflation has remained low. Undeterred, many economists continue to warn investors.

The first thing the Federal Reserve did in response to the financial crisis was to reduce the rate at which banks borrow money, slashing it from 5.25% to zero.“Banks borrow money?” you may ask. “I thought banks lent money!” They do both. Banks lend more money to the public than they have, and whenever they do not have enough money to process a customer’s loan, they borrow from other banks.1

Even with this rate at zero, the economy languished. With only one tool left—QE—the Fed, with a click of a mouse, created trillions of dollars to buy longer-term bonds from banks, pension plans and asset managers, hoping those purchases would lower longer-term interest rates and spur more bank lending.

The banks that sold bonds to the Fed received money they then deposited at their bank, namely the Fed. Those bank deposits are called reserves. From August 2008 to December 2014, excess reserves rocketed from $1.9 billion to $2.6 trillion.2

Most inflation fears stem from these excess reserves. Economists are warning investors that, when banks multiply those excess reserves into loans, inflation will spike.

In 2013, one of the most prominent economists in the U.S., Harvard professor Martin Feldstein, warned investors, “The banks can use these excess reserves to create loans and deposits, which will increase the money supply and fuel inflation. 3

John Taylor of Stanford University, another highly acclaimed economist, also in 2013 warned investors, ”When the economy begins to heat up, the Fed will have to sell the assets it has been purchasing to prevent inflation. If its asset sales are too slow, the bank reserves used to finance the original asset purchases pour out of the banks and into the economy.” 4

Economists were wrong about reserves fueling inflation, because banks can only lend them to other banks. Consumer and businesses demands, not reserves, determine loan amounts and frequencies. During the housing boom, banks had almost no excess reserves, but everyone and their brother got a loan.

But the inflation hawks are at it again. On March 30, 2015, Martin Feldstein claimed, “The Fed should accelerate its projected rate increases and communicate the new projections explicitly to markets. Unless this is done, the combination of rising inflation and increasing real interest rates may expose the economy to an unnecessary risk of financial instability.” 5

During these past five years—the time period QE was being implemented—the Barclays Capital U.S. Aggregate Bond Index, a proxy for the U.S. bond market, grew 4.41% a year. 6

And more importantly, during the last bear market in stocks (Oct 2007-March 2009), when the S&P 500 lost 56% of its value the bond index was up 6.97% in 2007 and 5.24% in 2008.(Indices mentioned are unmanaged, do not incur fees, and cannot be invested into directly.)7 8

Bonds play an important part in a portfolio, so unless an investor’s risk-tolerance or goals change, it is unwise to scrap or reduce the percentage of their portfolio invested in bonds. If, in the future, inflation does spike, investors with diversified portfolios can implement fallback strategies: adding shorter-term bonds, inflation-protected bonds, and/or emerging market bonds. (Asset allocation and diversification strategies cannot assure profit.)

Remember, the asset managers and pension plans that sold bonds to the Fed used those proceeds to purchase risk assets. Those purchases propelled those assets higher, and higher prices entice speculators who borrowed money to buy those same risk assets. The public, frustrated by the low interest rates, also purchased those risk assets. So, in addition to excess reserves, the other side effect of QE is that risk assets, such as stocks, get expensive.

These are the opinions of financial advisor Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice.

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  1. Board of Governors of the Federal Reserve System, http://www.federalreserve.gov/monetarypolicy/bst_crisisresponse.htm
  2. Ben R. Craig and Matthew Koepke, “Excess Reserves: Oceans of Cash,” February 12, 2015, http://employees.csbsju.edu/jolson/ECON374
  3. Martin Feldstein, “The Fed’s Dangerous Direction,” The Wall Street Journal, Jan 2, 2013, http://www.wsj.com/articles/SB10001424127887324669104578204190538524144
  4. John B. Taylor, “Fed Policy Is a Drag on the Economy,” The Wall Street Journal, Jan. 28, 2013, http://www.wsj.com/articles/
  5. Martin Feldstein, “The Fed Needs to Step Up Its Pace of Rate Increases,” The Wall Street Journal, March 30, 2015, http://www.wsj.com/articles/martin-feldstein-the-fed-needs-to-step-up-its-pace-of-rate-increases-1427758492
  6. iShares by Blackrock, https://www.ishares.com/us/products/239458/ishares-core-total-us-bond-market-
  7. Standard & Poor, “Dow Jones Indices Limiting Risk Exposure With S&P Risk Control Indices,” http://www.spindices.com/documents/research/limiting-risk-exposure-sp-risk-control-
  8. Stocks and Bonds, Calendar Year Performance 1980-2013, http://bonds.about.com/od/bondinvestingstrategies/a/Stocks-And-Bonds-Year-By-Year-Total-Return-