The Case Against Bonds for Now

Investors are fleeing equities and running to government bonds for protection against the economic uncertainty surrounding slower growth and higher tariffs.  For good reasons, too.  Bonds historically perform well during recessions when interest rates fall.  Remember, bond interest rates are inverse to bond prices.  As rates fall, the value of a bond goes higher.  But is this the case in early 2025?

The economic uncertainty caused by trade wars and higher tariffs pose significant headwinds to economic activity.  Rising tariffs influence interest rates, inflation, and overall economic growth.  And as tariffs increase, the cost of goods rise, contributing to inflationary pressures. Herein lays the problem.  You see, inflationary pressures require central banks to raise interest rates – not lower them as is common in a recession. And rising rates will force bond values lower.

Now, some bond investors are perfectly fine knowing that the value of their bond is going lower because they have no intention of selling the bond.  In that case, bonds can perform their job well.  Let me illustrate this concept.  If an investor buys a 10-year Note at par ($1,000) with a 4.25% coupon, the investor is guaranteed to receive $42.50 annually in interest payments from the US Treasury (or $425 over the ten-year period of the bond). If interest rates rise to 5%, the current value of the bond will fall to $850 – a 15% loss of market value.  But again, the loss remains an unrealized loss UNTIL the investor sells the bond.  If the investor holds the bond for the full ten years, the investor still receives $425 in interest payments and a return of the $1,000 par value.  In other words, no harm, no foul.

Economically, when interest rates are rising in the presence of slower economic growth, the economy goes through a period of stagflation – stagnant growth and higher interest rates.  And because central banks are much more concerned about inflation than slower economic growth – they are forced to keep rates higher for longer.  I think the Fed will realize this sooner rather than later when they plan to lower rates in June of 2025.  Based on economic conditions right now, the Fed will not be able to cut rates in June – and in fact, may find themselves raising rates to stem higher inflation.  

For bond investors looking for safety in bonds, inflation-protected securities (TIPS), short-duration bonds, or high-quality municipal bonds can help mitigate the risks of inflationary pressures on a portfolio.  But, investors must monitor central bank policies closely, as interest rate adjustments in response to tariff-driven inflation can influence bond performance.

So while increasing tariffs can introduce volatility, they can also create opportunities. rising inflation will enhance the appeal of inflation-linked bonds, while economic slowdowns might support high-quality government bonds. By understanding the interplay between tariffs, inflation, and interest rates, investors can better position their bond portfolios to navigate these economic shifts.

‍