The world’s biggest bond market continues to perplex even the most sophisticated investors. Longer-term Treasury rates have been falling in 2017 despite a series of rate hikes from the Federal Reserve, frustrating both savers and traders that are set up for the so-called reflation trade. More recently, rates have backed sharply up after the European Central Bank weakly signaled a possible tapering of bond purchases.
U.S. Treasury rates drive so much in finance that it is not a stretch to say that they are “the straw that stirs the drink.” Readers of a certain age will recognize the self-descriptive remark uttered by the famous N.Y Yankee Reggie Jackson back in 1977. Jackson’s comments were later poo-pooed by team captain Thurman Munson. But Jackson had the last laugh being named that year’s World Series Most Valuable Player. Similarly, U.S. Treasuries may be the market’s Most Valuable Input, or MVI, given that it forms the basis of risk-adjusted discount rates, used to calculate the present value of future cash flows – things like dividends, coupons, and rental income.
So, how do investors decide if today’s 10-year Treasury rate of 2.37% is too low, too high or just about right? Like everything else in finance, the answer to the question depends on who you ask. Let us start with the Quants since quantitative investing is so popular these days. Quants typically model interest rates, including Treasury rates, as a mean reverting process. The key parameters are an average interest rate over time and something called mean reversion speed. Essentially, this approach assumes that interest rates have a long-term memory process that asserts itself over some period. Estimating the time it takes for interest rates to mean revert is obviously challenging. However, by this estimate, 10-year Treasury rates look way too low now since a longer-term average, going back to 1977, is closer to 6%. You can easily vary the look-back period and reversion speed, but you will likely draw the same conclusion since today’s rates are near historic lows. The main problem with the Quant approach is that it assumes interest rates are stationary, meaning that a true average does not change when shifted in time. That’s a very strong assumption.
What about the Economists? Although Economists rarely agree with one another, most will argue that there is fundamental relationship between growth, productivity, and interest rates. Over the past 10 years, U.S. real GDP, which itself is a function of productivity, has averaged just 1.33%. Now, adding average inflation (using PCE- Price Index) over the same period of 1.59% to arrive at a nominal return suggests that 10-year Treasury rates should be nearer to 2.92%, which is again above the current rate. So, our Quants and Economists agree that Treasuries look overvalued.
The market technicians in the house will likely note that the charts have recently rolled over and bonds are headed for losses. The charts signal that 10-year rates are like to revisit 2.60%, last seen in March 2017, before moving even higher. The 2.60% 10-year yield represents a virtual Sykes-Picot line, that if violated, will lead to serious bloodletting in the bond markets. I respect the charts but find they are better suited for timing signals rather than for value assessment. Professional traders, the hedge fund types, will usually be aligned with the technician view and are now in the process of flipping from long to short
I take a different approach as an investor. I simply want to know much compensation I am being offered in return for parting with my money. Let’s say that I am considering buying 10-year Treasuries right now. At a minimum, I want to be compensated for the real 10-year rate, which today is 60 basis points. The real rate compensates me for deferring consumption in favor of savings. Sure, 60 basis points does not sound like much. It isn’t, but it’s a mountain more than you get by investing in other developed markets. Next, I want to be compensated for inflation risk which is currently running at around 1.80%. Adding the two together, I arrive at 2.40%, which is close to the actual yield of 2.37%. I am not thrilled with 2.37%, but at least I know I am receiving some compensation. Ideally, I prefer when Treasuries offer an additional risk premium to insulate my investment against higher real rates and higher inflation than is currently priced into the market. Unfortunately, that is not the case now. The risk premium on 10-year Treasuries is near zero.
Of course, we can all debate if I am using the right approximations of real rates and inflation. I derived both from the TIPS market. The key point here is the U.S. Treasuries look fairly valued to me. Now, if you think real rates and inflation are headed higher, then Treasuries do not offer value. Similarly, if you think both inputs are going lower, then you may want to add 10-year Treasuries to your portfolio. It is also possible to see scenario where the risk premium goes up and the price of treasuries decline as the Federal Reserve reduces its balance sheet. That will be a good outcome for active Treasury investors and seems to be aligned with the scenario playing out during the past two weeks.
Bottom line: U.S Treasury’s should be an integral part of most long-term portfolios that are seeking to grow wealth in a risk sensitive manner. Right now, 10-year U.S. Treasuries look a bit expensive to me but not wildly so. That calls for a slightly underweight position. Lastly, please remember that U.S Treasuries are traded in global markets and compete for investor money on both an absolute and relative price basis. The fact the 10-year yields remain super low, despite recent selloffs, in Germany, Japan, and the UK can provide some support for the U.S. brand.
Disclosure: I am/we are long TLT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.