For 10-Year Treasurys, 3% Yield Isn't A Tipping Point

by: Janus Henderson Investors

While yields will continue to rise, the speed at which they do so is more important than where they eventually end up.

Rising yields may result in an inflow of money to Treasurys by yield-hungry overseas investors.

An absence of a sharp uptick in inflation should contain the pace at which Treasury yields rise, preventing a shock to markets.

By Ashwin Alankar

In an interview with Bloomberg TV, Dr. Ashwin Alankar, Head of Global Asset Allocation & Risk Management, shares why he believes the speed at which the yield on the 10-year Treasury rises shouldn't increase because investors have few other options in sovereign debt in developed markets, while there's little sign of a significant spike in U.S. inflation, which would hurt the value of fixed income payments.

Julia Chatterley: For the first time in four years, the U.S. 10-year yield has crossed the 3% threshold, spurring a ripple effect across the asset classes, the U.S. dollar trading at a three-month high and equities turning positive as we head toward the close. As I mentioned before, once again, industrials under pressure. Joining us now for more is Ashwin Alankar, Global Head of Asset Allocation at Janus Henderson, and he joins us from Denver. Great to have you with us. Let's talk about what we're seeing in the rates market right now, and in particular, this spur that it seems to have given at least for now in the U.S. dollar. Talk me through what you think we see and where rates go and where the dollar goes here, too.

Ash Alankar: Absolutely. Good afternoon. Well, I think what's on everybody's mind today, are we entering a whole new world, given this ever-elusive 3% interest rate on 10-year bonds has finally been hit. And the fear is, are we going to now see a sharp accelerated sell-off in bond? We believe the bond market is absolutely not at a tipping point. For rates to sell off violently, for bonds to sell off sharply at an accelerated pace, one of two things needs to happen. One, you need a mass exodus out of U.S. Treasurys, but for a mass exodus to unfold, you have to find a better place to park your money and the reality is outside of the U.S. in developed markets, no bond is offering better yield than U.S. yields. And in fact, if you buy a non-U.S. developed market bond you likely are going to lose money in real terms because real rates are negative almost everywhere outside of the U.S. So we don't see that mass exodus unfolding. A second catalyst to a mass sell-off in bonds is a jolt to inflation, which would obviously affect U.S. bonds and global bonds. We don't see that happening and all credit goes to Janet Yellen and her team where they took on a very proactive stance to tightening monetary conditions. They did not allow the music to play for too long. They did not allow the punch to flow for too long. And hence, they mitigated the risk of runaway inflation. So we don't see an inflation scare anywhere near term in the horizon.

Joe Weisenthal: Where could rates go over in the long term? It's one thing for the wheels to not fall off the bond market, but we have seen this pretty substantial move up. Where could you see things settling out or topping out?

Alankar: Excellent question. We believe normalization, while it's underweight, it's not complete, and where it's not complete is in the real rate space. So you look at 10-year yields right now, they're around 3%. About 85 basis points of that is real yield. So what is that telling you? That intuitively is telling you that the bond market believes the average real GDP in the U.S. over the next 10 years will be around 85 basis points, and that's way too low. A more normal level of real GDP over the next 10 years, one could argue, is somewhere between 1.5 and 2%. So we think real yields have another 75 basis points at least to go up, which brings your 10-year yield to about 3.7, 3.75%, which we think is normal. But your point is a very important point. It's not about where interest rates settle at, it's about the trajectory and the path they take to that new normal. Is it going to a measured, moderate, gradual, continuous path or is it going to be a violent, chaotic path? And we think it's the former.

Scarlet Fu: What would make it more violent, more jagged in terms of that trajectory, that's something that would shock the system?

Alankar: Inflation. Inflation will shock the system. If we have unexpected inflationary pressures, the Fed will have no choice but to raise rates much quicker and tighter monetary conditions will translate to much higher real rates. And if real rates jump up too high, you start questioning whether or not corporate America in the economy can handle those higher real rates if they come about faster than expected.

Fu: So, very quickly here, Ash, how does this all change equity investors' perspective when it comes to U.S. stocks versus emerging market stocks or international stocks, those in Europe for instance?

Alankar: I think that there are a lot of things that you have to pay a lot of attention to. So for one, interest rates going up, is that going to affect growth stocks, so say technology stocks more than value stocks? It's going to affect growth stocks more. Growth stocks are longer duration assets. Interest rates go up, longer duration assets suffer. Now if you think about emerging markets versus developed markets, historically, rates go up in the U.S, U.S. dollar strengthens. We are seeing that today. And that has been bad for emerging markets because emerging markets, historically, so think about the Asian crisis in the '90s, they issued a tremendous amount of U.S. dollar debt. U.S. dollar funding becomes more expensive. They have a hard time financing the debt, but they learned their lesson. Right. People are smart. They learn their lesson and today emerging market countries don't issue large U.S. dollar debt. So a stronger dollar is good for emerging markets because the U.S. being the biggest consumer in the world, emerging market products, emerging market imports to the U.S. are cheaper. So we like emerging markets.

Weisenthal: Ash, real quickly, one of the things giving some boost to the dollar lately has been that gap between U.S. rates and rates in the rest of the world. How much does that draw in foreign money back into the bond market and keep a lid on some of those rates?

Alankar: That's an excellent question. When I was talking about a mass exodus out of U.S. Treasurys, you in fact may see a mass exodus into U.S. Treasurys for that exact reason. So think about Japan insurance companies. They're very, very risk-adverse. If they buy non-Japanese bonds, they hedge that currency. Japan insurers, earlier this week, went out and they said the yield differential between JGB, so Japan 10-year bonds and U.S. 10-year bonds, is so wide and so attractive that we're willing to buy U.S. debt without hedging the currency. So that's going to drive the U.S. dollar higher, but at the same, if you have that influx into U.S. debt markets, it's very hard for interest rates to get out of control and violently shoot up. So there are many reasons and many forces that exist today, which I believe will keep U.S. rates rising to that 3.7% level at the 10-year point at a gradual and moderate rate, which is all good news.

Chatterley: Ashwin, very quickly as well, if you're very comfortable or uncomfortable with what's going on at the higher duration part of the curve, I've lost count of the number of people that say there's opportunity at the front end of the curve here, but if you don't want to take longer day Treasury exposure, go into T-bills, go into the front of the curve. What do you think of that?

Alankar: Excellent idea. The term structure here in the U.S. is way too flat. Term premium has disappeared and term premium will come back. It will come back once risk comes back to the interest rate market. So right now if you think about the amount of carry you can earn by holding front-end bonds versus the volatility or the risk you expose yourself to, front end looks much more attractive than the back end. It's too flat. There's no point right now in taking on that duration risk if you're not getting compensated for it. So I think your point is a very, very valid point.

Fu: Thank you. Ash Alankar, Janus Henderson Asset Allocation Global Head, thank you so much.

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