What goes down must come up
What goes down must come up
Bond prices are falling, but the inflation outlook for airline points has never been better
Photo by yousef alfuhigi on Unsplash
Hello,
Welcome to Known Unknowns, a newsletter that is never giving up on collecting airline points and long-term bonds.
The bond bears’ day has come
I spent a significant part of my career trying to model long-term interest rates. It was a fruitless and thankless task, and in many ways, impossible. I don’t think anyone has a good empirical model for the term premium—at least, not one that can be reliably estimated. But the one thing that was supposed to be true was that rates mean-revert—or if they go very low, they eventually go back up. Then the 40 years of falling rates, especially the last 10 years of near-zero rates, convinced everyone otherwise.
It's the widow-maker’s revenge! Rates are up, and all of us perpetual bond bears are churning out our reasons why we think rates will stay high—I hear 6%, 7%, or more! I have no idea what will happen. Maybe we will go back to 2019 rates and forget this ugliness ever happened. But more likely we are in a new regime, with more volatility at the very least. And so it is time to vanquish three myths about bonds that took hold in the low-rate era.
1. All safe bonds are risk free. When rates are low, what’s the difference between a bill and a 10-year treasury? The U.S. won’t default (at least not explicitly), so everything is risk free! Not anymore. Now, in a more uncertain rate environment, we need to be careful of what we call risk free. There is no longer any room for error. If you want nominal stability and liquidity, buy bills. If you are running a pension fund and your liability duration is 62 years, that Austrian century bond isn’t looking too bad.
2. The Fed determines long-term rates. Actually, its determined by macro factors, supply and demand for bonds (which point to higher rates for longer with all that debt we are racking up), and the term premium, which is a tricky animal. The hard part is estimating the inflation risk premium part of it. It is especially now, after years of it effectively being zero, when everyone had forgotten that inflation was a problem. People such as Paul Krugman may take comfort that break evens are low and stable-ish. But the distribution around inflation expectations and measures of uncertainty are elevated and have not changed much in the last year. This suggests a bigger risk premium. Always look at the second moment.
3. An aging population will bring down rates. Not with our unfunded entitlement state!
Who knows what will happen? I’d bet on more volatility and probably higher rates going forward.
Remember when everyone argued that debt was costless because rates were near zero and growth was positive? And then we assumed that would be the case forever. Enough so the government took on lots of short-term debt to finance its five-year spending bonanza. But now that rates are up, it seems debt does have a cost (though some people are still in denial on that point). If rates stay high, I don’t expect a U.S. sovereign debt crisis, but it could mean lower growth and much higher taxes or inflation.
Thankfully, households and corporate debtors managed to lock in low rates when they had the chance. But if rates stay high in the coming years, things could get messy fast. Does that count as a soft landing?
End of points?
It is probably not a surprise that I am a point fanatic. Like any gambler, I just love the game I am playing, in this case with the airline—I am convinced I can beat the house. Or maybe it’s because I have underutilized advanced math skills and I can never resist an optimization problem with no global maximum. This is exactly the problem the airlines pose to you, and I do love ambiguity. That’s the name of the game, and one reason I probably lose in the end is that the airlines are always changing the rules and devalue points. My airline already moved to spending instead of miles traveled to obtain elite status. But people sure are angry Delta is doing it too. Just wait until Congress cracks down on swipe fees and kills airline credit cards altogether.
If it is causing you stress, I find peace by recalling the first rule of my point game: “stay detached from the outcome.” And by outcome, I mean upgrades or not having to gate check my bag. No one, no matter how good their point game is, is entitled to upgrades, lounge access, overhead space, or free flights. Changing the rules, or just eroding your points with inflation, is part of the game we sign up for. Maybe one day I will give up, as I tend to when I am not traveling as much, and find I have more time for productive hobbies.
But if you do decide to hang on with your airline, things may be getting better for point enthusiasts. Fewer people chasing points means less point inflation—after all, if fewer points are issued, inflation should go down (another test for Milton Friedman), and fewer elite fliers means that elite will become more, well, elite.
In other news
What’s happening at U.K. universities does not bode well for U.S. public pensions.
Until next time, Pension Geeks!
Allison
1. I was baffled that the US government wasn't auctioning off as many 10-30 year bonds as they possibly could over the past decade. I was also baffled that they didn't auction off 50 year bonds to pay for the infrastructure spending that has very long lifespans. I would have stuffed as many of those 10-50 year bonds into the market as it would take from 2012 through 2021. They should have pushed the duration of government treasury bill/bond fund to 10 years.
2. The average homeowner figured this out over the past few years which is why new mortgage rates are skyrocketing (all the way to 1990s rates!) but the outstanding mortgage average rate is close to the lowest on record. 70% of mortgages have rates less than 4%. The dumb money appears to have been the smartest money in the market.
https://twitter.com/GSORealtors/status/1678414152803418113
3. You wrote "Changing the rules, or just eroding your points with inflation, is part of the game we sign up for. " This is true for pretty much anything ranging from Social Security, pensions, Medicare and Medicaid, to retirement accounts with rules that are all dictated by the federal and state governments. Corporations have already changed the rules on who can get pensions so that is down to only a very few. I have no idea what is going to happen to Social Security when the Trust Fund runs out, but it is not going to be pretty. We will be collecting SS by 2033, so when we refinanced our mortgage in 2021, we went with a 15 year loan at 2.625% (half of current money market yields). One of the reasons was that it would come due in 2036 and finishing the mortgage payment and interest would partially offset the SS payment drop that is almost certainly coming for us around 2033. I think they will figure out how to maintain SS payments as promised to people receiving less than the median SS payment, but everybody above that should be prepared for a haircut. The uncertainty about that will have a growing impact on savings and spending rates of retirees and near-retirees over the next decade. Over 65 people already make up a large percentage of consumer spending - a reduction on that over the next decade could have a serious impact on economic growth.
Considering the fracturing of multi national organizations and the globalization of production do government levers of economic, trade, fiscal and monetary policy have any chance of maintaining the level of influence they once had?