James Carville, Bond Intimidation & The 4% Cash Strategy

James Carville, Bond Market Intimidation, and the 4% Cash Strategy

Political strategist James Carville famously said:

"I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody."

Right now, everyone is talking about the bond market. The recent increase in interest rates reminds me a lot of 2022. As interest rates increase, the fair market value of bonds declines. This leads to temporary losses in portfolio value on paper for fixed income holdings.

However, unless you trade bonds actively, this drop in fair market value is temporary. As a bond gets closer to its maturity date, its fair market value increases back toward its par value. So if your intention is to hold bonds to maturity, short term movements in fair market value are not important. The bonds keep paying their scheduled interest payments, which can then be spent or reinvested.

Higher rates also present a strategic portfolio opportunity: generating capital losses to offset capital gains by selling bonds that have dropped in market value and exchanging them for similar bonds. This allows you to lock in the tax loss without losing your income stream. Where appropriate, that will be an active portfolio strategy while interest rates remain elevated.

Cash Opportunities and the Consumer Inflation Gap

Another immediate opportunity in fixed income is that 9-month through 2-year U.S. Treasuries offer very attractive, above-inflation rates of over 4% to park cash safely.

Meanwhile, stock market valuations remain high because corporate earnings have outpaced the Federal Reserve's above-target inflation rate so far. However, this could prove challenging going forward as future corporate earnings face comparisons against today's record setting earnings numbers.

We are also monitoring a key divergence in inflation expectations: institutional bond market investors currently hold 5-year future inflation expectations at 2.33%, which is at the high end of a very narrow historical range. However, everyday consumers expect inflation to remain at 3% over that same period.

Because consumer inflation expectations have a high correlation with actual future inflation, keeping current consumer expectations above 3% puts us in danger of having higher inflation permanently baked into the broader economy.

So far, the stock market has remained sanguine about higher interest rates, but that is certainly not the case if you are currently looking to purchase a home and shopping for a mortgage.