Retirees, watch out: Long-term interest rates could rocket much further, warns this legendary fund manager

It’s a topic that’s especially important to retirees and anyone else relying on their portfolio for regular income. Such investors are typically advised to keep much or most of their portfolio in bonds.

In his latest letter to investors in his Pershing Square fund, Ackman warns that long-term interest rates could easily rise another 27% from here.

The yield on 10 Year Treasury notes, the central long-term interest rate of the bond market and indeed the entire global economy, has risen in a month from 3.8% to 4.3%, the highest level since 2007—before the financial crisis.

But Ackman says this rate only looks high because recent history has made us complacent about rates. Actually by the standards of math and history, he says, the yield could easily jump all the way to 5.5%.

That would entail a fall of about 10% from here in 10 year Treasury bond prices, and would almost certainly plunge the stock market into turmoil and threaten real estate as well.

“We believe that long-term interest rates can continue to rise substantially from current levels,” Ackman writes. “Investors have become so accustomed to low long-term rates for many years that 4.3% seems like a high long-term rate for many fixed income investors.” He adds that when you look at history and do the math, “We do not believe that current levels of long-term Treasury rates are high.”

His math is pretty straightforward. Ackman suspects inflation may stabilize at 3%, not the 2% the Fed is hoping for. Then, he says, you should add on “the equilibrium real short-term interest rate of 0.5%,” and “the historical 2.0% average term premium for long-term rates relative to short rates.”

In other words: Inflation at 3%, and long-term Treasury bonds paying 2.5% above inflation. 

Ackman, to be sure, is talking his book: His hedge fund holds bets on higher interest rates, counterbalancing various bullish bets on stocks. “We continue to hedge the risk of a rise in 30 year Treasury rates because we remain concerned about the risk of higher long-term interest rates on equity valuations,” he writes. This is a typical hedge fund strategy, balancing bets in the hope of making money in any market. 

Whether he’s right is another matter. Ackman’s argument is based on two separate things. The first is that the Fed will have to accept a higher rate of systemic inflation than it wants. The second is that in future buyers of Treasury bonds will demand a higher “real” rate of interest, meaning a rate of interest above inflation.

Why would the Fed accept 3% inflation? Ackman’s argument isn’t unique. New structural factors in the economy will make inflation more persistent, he argues: These include higher defense spending, energy scarcity, the costs of switching to green energy, more trade protection and manufacturing “onshoring,” and a stronger bargaining hand for labor.

Meanwhile, he sees several reasons why Treasury bond buyers might demand higher “real” rates in the future. One is simply the risk posed by rising inflation (just mentioned). Others are about the supply and demand of Treasury bonds. As America’s national deficit balloons, the government needs to borrow more, while at the same time many foreign countries—led by China, naturally—want to lend Uncle Sam less. Ackman notes that the Treasury will be trying to sell another $1.9 trillion in bonds in the second half of this year alone.

Investors can minimize inflation risk by investing in inflation-protected Treasury bonds instead of the regular one. (I’ve written about this too many times to mention, and it’s what I do with my own money.)

As for Ackman’s argument about “real rates” rising to 2.5%, only time will tell. Currently inflation-protected Treasurys sport real yields of 2%. Another half a percentage point rise would be remarkable. It could certainly happen, but I’m not betting on it.