On Wednesday, we got our monthly update on the rate of inflation — 1.7% for the year ending February 2021. That’s higher than it was the prior year, and there is good evidence it will likely climb higher in the coming months as the economy pulls out of the pandemic at a potentially very fast rate. That’s good news, provided inflation doesn’t get too high in the process, which is a distinct possibility in today’s macro economic and market environment.
Also this week, interest rates continued to spike higher with the 10-Year U.S. Treasury reaching 1.63% as of this writing. That’s bad news if you’ve been intending to take out a mortgage and haven’t gotten around to it. Good news if you want to buy a 10-Year bond right now…or is it?
Do the math between the paragraphs above: You can earn 1.6% on a 10 year Treasury bond, which is about 1.0% after taxes, and inflation is 1.7%. So you are losing -0.7% per year; and worse if inflation climbs higher.
Of course, cash is worse yet — earning between 0.01% and 0.5% leaves you even deeper in the negative-after-inflation camp. But is cash really worse?
The first thing we need to acknowledge is that bonds go down in value when interest rates go up. I spoke with an investor (not a client) recently who, contrary to my earlier advice to them, placed a large sum of money into a bond fund because the low yield on cash was just too painful. My advice was to be patient while the necessary analysis and planning work was done so we could identify appropriate long-term opportunities. Since the start of the year, the U.S. bond market has experienced a negative total return of -3.7%. At current after-tax yields, it will take nearly 4 years to break even from this decline.
In this case, cash would have been better. So the second thing we need to acknowledge is that cash represents an option to buy other assets at cheap prices. Sometimes the low yield on cash is just the short term rent we pay so that we can scoop up bargains when it becomes available. When that happens, and it happens often, the total return on the decision to hold cash goes up dramatically.
To build and preserve wealth requires an understanding of the economic and market risks we face such as inflation and interest rates, patience while we explore options and design a strategy that is unique to your lifetime goals and objectives, and a willingness to utilize the full spectrum of asset classes with a keen awareness of how to mitigate risks and keep our options open for when opportunities arise.