Money

Interest Rates Must Rise to Meet Inflation

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The relationship between interest rates and inflation has gotten out of whack.

I keep seeing data points that make my head spin.

The chart below shows that a whopping 85% of high-yield bonds now carry yields that are lower than the current inflation rate.

85% of High Yield Bonds Yield Less Than Inflation

You can see from the chart that, over two decades, normally just a small portion of high-yield bonds have carried a yield less than inflation.

Now almost all of them do!

That’s not how the market is meant to work, folks…

High-yield bonds are meant to provide an income stream that far exceeds the rate of inflation.

Owning bonds with yields that are lower than the rate of inflation is a guaranteed way to lose money.

It means you earn less in interest than what the bite of inflation takes away from your net worth every year.

I pulled the data for the next chart from as far back as I could go.

What this chart shows is the effective yield of the B rated U.S. high-yield bond asset class versus the rate of inflation as captured by the consumer price index over the last two decades.

Inflation vs. the Yield on B Rated High-Yield Bonds

It’s not hard to spot the anomaly.

The green line (the yield on B rated bonds) is supposed to be well above the teal line (the rate of inflation).

You can see that, throughout the majority of this time period, the yield on B rated high-yield bonds exceeded the rate of inflation.

As it should have.

Then, in May of this year, the two lines crossed so that the B rated high-yield bond asset class now yields less than the rate of inflation.

We Know What Has to Happen – So We Better Prepare

What we are seeing in these charts are huge abnormalities.

As a stock market investor, I’m frightened by them.

The normal relationship between interest rates and inflation has gone completely out the window.

At some point, though, things have to snap back to get this relationship to normalcy.

For that to happen, one of these two situations must unfold:

  1. Inflation has to cool and then reverse rather quickly
  2. Interest rates need to soar.

At this point, I’m betting my money on No. 2, and I’ll tell you why…

Despite being faced with blazing-hot inflation, the U.S. Federal Reserve is doing nothing to cool it.

Nothing.

In fact, it is continuing with the most extreme pro-inflationary monetary policy that we have had in our lifetimes.

As the Fed stands on the sideline and fuels inflation, there is a growing chance that inflation will get truly out of control.

If that happens, there’s only one way to stop it… The Fed will have to aggressively raise interest rates.

Surging interest rates are not going to be good for the stock market.

The stocks with the most optimistic valuations are going to get hit hard.

The technology sector is particularly vulnerable.

A better sector to own during rising inflation would be financials, which benefit from rising rates.

In this area, I still like the American banks, which are reasonably priced and have huge leverage to rising interest rates.

Banks benefit from rising rates because their lending spreads widen.

Back in May 2020, I pounded the table on the banking sector and the SPDR S&P Bank ETF (NYSE: KBE), which has doubled and trounced the S&P 500 since then.

My May 2020 Banking Sector Call Has Outperformed

I don’t see the banks repeating that kind of performance going forward, but this exchange-traded fund (ETF) should handily outperform the tech-heavy S&P 500 in a rapidly rising rate environment.

The reality is that something has to break in the coming months.

Either inflation somehow cools despite the Federal Reserve still fanning the flames…

Or we are going to see a rapid and powerful move in interest rates unlike anything we have seen in quite some time.

Investors should brace themselves by stocking up on companies that should outperform in a rising interest rate environment, like American banks.

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