By Sean Stannard-Stockton, CFA
When the Federal Reserve Board meets, most of the media attention is focused on whether or not it has made a change to the Federal Funds rate. But for long-term investors, it is more interesting to understand the Fed’s beliefs about the course of how rates will change over time. Whether it hikes rates this quarter or next is not material to the value of long-term assets like stocks.
But whether the 10-year Treasury yield (a long-term rate that the Fed can influence but does not control) averages 2% or 5% over the next decade will have quite a large impact on equity and bond valuations.
So, one of the more interesting parts of the Federal Reserve’s press release after each meeting is the update as to how the Fed expects rates to evolve in the future. At the most recent meeting last week, the Fed said that the median member expects the Federal Funds rate to be hiked to 0.75% by the end of this year, raised to 1.25% by the end of 2017, upped to 2.00% by the end of 2018 and raised to 2.75% by the end of 2019.
Historically, we know that the 10-year Treasury yield runs, on average, about 1% above the Federal Funds rate. (Indeed, at 1.56% today, it is 1.06% above the current Federal Funds rate). So, it is reasonable to think that the Federal Reserve expects the 10-year Treasury yield to be running at about 3.75% by the end of 2019. We can also back into this estimate by noting that historically, the 10-year Treasury yield has tracked the rate of nominal GDP growth.
In its most recent release, the Fed said that its median member thinks that long term, real GDP will average 1.80%. Since the Fed is targeting a 2% inflation rate, this would lead to a 3.80% nominal GDP rate, essentially the same rate as our implied 3.75% 10-year Treasury yield for year-end 2019.
This is all public data and there’s no proprietary insight here. We’re simply putting some context around the Fed’s very public statements.
But the implication of this outlook is somewhat shocking. In essence, the Federal Reserve is telling investors that they should expect to lose money over the next couple of years if they invest in the 10-year Treasury.
Given the current yield on the 10-year Treasury, if the year-end 2019 yield is 3.75%, investors in that bond would have earned a total return over that time of negative 8%.
The majority of investors view bonds as a way to keep assets safe. Bonds are intended to generate a modest return relative to equities, but with far less downside risk. Given the continuing preference investors currently have for “safe” assets, investors have been pouring money into bond funds even as equities have been in the midst of a strong, multiyear bull market. While we think bonds play an extremely important volatility control role in investors’ portfolios, we do not think that any asset priced for multiyear negative returns can be considered “safe.”
The 10-year Treasury is a “safe” asset in the sense that there is no material risk that the interest and principal payments will not be made by the government as promised. But an unsafe price can make a “safe” asset risky.
Luckily for investors, there is a simple solution. Short-term bonds, such at the 1-year Treasury, are likely to earn a yield that is close to the rate at which the Federal Reserve sets the Fed Funds rate. Given the Fed’s own projections, this would lead to a total return of a little over positive 5% — or about 1.50% per year — from now through the end of 2019.
Investors in longer-term bonds should make this investment only with a recognition that they are betting against the Fed and they must believe that their own forecasts of longer-term invest rates are superior to those of the Federal Reserve members.
*This calculation assumes an approximately flat yield curve in the 6-10 year range, consistent with historical averages. At year-end 2019, the bond would be trading at a 13% discount to par in order to show a 3.75% yield to maturity and the investor would have collected approximately 5% in coupon payments for a total return of -8%. Of course, an investor who holds the bond to maturity will earn a positive return of 1.56% per year or a cumulative return of 16.7% over the 10-year period ending in late 2026.
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