The Price Of A Good Night's Sleep

by: Russ Koesterich, CFA

Even with the recent market rally, investors are still placing a significant premium on those assets perceived as “safe”. Case in point: The U.S. Treasury market. By one measure – real yields measured against core inflation – long-dated Treasuries are offering the worst returns in over 30 years. The flip side of this trade is a persistent aversion to assets perceived to be the most risky, particularly Europe. Even in the more stable, northern parts

of Europe many markets are trading at 8 to 9 times earnings, with dividend yields ranging from 4% to over 5%. In a low yield world, this strikes us an interesting long-term opportunity.

Negative Returns and More Risk: What Could Go Wrong?

In the seemingly unstoppable march toward a 0% long-bond, U.S. Treasuries recently notched another milestone. In September, the yield on the 10-year Treasury note dipped below the rate of core inflation for the first time in 30 years. In recent months, the trend has continued. With rates still stuck at or below 2% and core inflation now at its highest level in over three years, the spread between the yield on a 10-year Treasury and core inflation is now at its most negative since 1980.

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While it is not uncommon for nominal Treasury yields to dip below headline inflation, it is much rarer to see Treasury yields below core inflation. Since the late 1950s, the average spread between the 10-year Treasury note and core inflation has been roughly 2.60%, consistent with the level suggested by most economic text books.

One reason it is unusual to see yields this low relative to core inflation is that this measure of inflation – which excludes food and energy prices – tends to be more stable. For example, nominal rates dipped below headline inflation in 2008. However, this was a temporary phenomenon caused by the spike in oil prices, which briefly drove inflation north of 5%. In contrast, core inflation never climbed above 2.50% in 2008 and real rates based on core inflation remained positive.

Today’s negative turn in real rates is significant. Historically, core inflation has typically been a better predictor of future inflation than the headline number. Given this, it is important to note that core inflation is still rising, albeit from low levels. In December core inflation hit 2.2%, the highest level since the fall of 2008. While none of this suggests that the United States is facing an imminent bout of inflation, it does suggest that inflation is at least stabilizing at normal levels, a conclusion reinforced by the recent anchoring of inflation expectations at around 3.2% (based on University of Michigan one-year inflation expectations).

As we’ve argued in the past, for long-term investors, buying a Treasury note or bond at these yields only makes sense if you expect the United States to slip into Japanese-style deflation. To the extent that does not look likely, it is hard to justify locking in a flat to negative real yield. It is even harder to justify this when you consider that today’s low coupon means that the effective duration – sensitivity to interest rates – is higher than in the past. In other words, not only are real yields negative, but Treasuries are likely to be more volatile.

Many would argue that yields are likely to stay low for some time, given the extension of the Fed’s quantitative easing program coupled with their long-term commitment to low short-term rates. But to some extent this is beyond the point. While Fed intervention may keep rates low and potentially mitigate the near-term risk of capital loss, unless inflation falls substantially investors are still accepting flat to negative real return. To add insult to injury, not only are they accepting a loss of purchasing power, but are implicitly accepting more risk in the process. That is a heavy price to pay for a good night’s sleep by investing in a safe haven.