Are Treasury Rates Too High?

Rob Arnott was quoted in on April 19 issue of Barron’s where said that the growth rates of 3% in 1945-1970 were a historical oddity due to demographics of rising population, etc.  He said real GDP is now 2% and will go to 1%. The implication is that, assuming inflation remains low, the current pricing for the 10 year Treasury with a yield of 2.7% is fair. Historically the 10 year Treasury yields the nominal GDP, so if real GDP is 1% and in the future inflation is 1.5% then the current yield is legitimate. Van Hoisington said last week in his quarterly newsletter than when short term rates rise this can actually slightly reduce long term Treasury rates. Indeed, the yield curve is heading towards flattening.

Raghuram Rajan, the Indian central bank head, said that QE may have actually facilitated cheap capital that allowed companies to buy labor saving equipment which resulted in a reduction of low skilled jobs, thus worsening U.S. unemployment.  Vanguard issued an economic report where they downplayed fears of duration risk for Treasuries.

I definitely believe that true deflation won’t happen and the end of the world won’t come, so I doubt that Treasury rates will go lower than what they are today. If one excludes the inflation of 1965-1981 then the U.S. has a long history of low inflation with real Treasury rates averaging 2.07%, which if added to an inflation rate of 1.5%, would imply that a 3.5% rate is legitimate. The 30 year Treasury is now at 3.49%.

There are an increasing amount of news reports that China will open their capital markets allowing the Yuan to be freely exchangeable. This will result in Yuan savings accounts being converted into dollars and invested by private citizens of China into U.S. stock and bond markets, which will hold down U.S. interest rates and make the dollar go up (and make the Yuan go down which helps China to export more).

I expect eventually Japan will experience a massive devaluation and capital will flee to the U.S. Treasury market. Currently Japan’s 10 year Treasury is 0.62%. If they suffer inflation and massive currency devaluation then that rate will rise, making their bonds go down in value.

Truly wealthy people and institutional investors often limit their allocation of equities and content themselves with the safety of a large dose of investment grade bonds despite the temptations that equities may offer. This tendency is greater for foreigners since they may have a lesser degree of trust for U.S. equities. Thus I expect the coming flood of Asian capital to be allocated by a significant amount into U.S. Treasuries. If you are truly wealthy with a net worth over $100 million then the $250,000 FDIC bank insurance amount is far too small, so you have to use Treasuries in lieu of a bank account.

I have stressed the importance of using the Sharpe ratio and Information ratio for investing. These compare the proportion of risk to reward, so a moderately successful investment with low risk gets the highest ratings. Much of the growth in the world economy has been in EM countries which are riskier than Developed countries, in part due to hidden problems and rewards in relation to corruption, cronyism, commodity bubbles, real estate speculation, debt fueled manias, etc. A proper assessment of hidden risk in these areas when added into the global economy implies that the world economy is riskier than previously thought and thus investors who seek good Sharpe ratios would be advised to trim their equity allocation and move into that rare and shrinking asset know as investment grade bonds (which has an air of the old cliché “they’re not making any more of it”) and buy this asset. In addition the principles of diversification can result in a higher realized return than a concentrated portfolio of riskier assets, even though in theory, riskier assets should return more. This is becuase excessive risk results in failure so the hoped for gain is not realized. It is a case of "less is more". These reasons will attract investor to U.S. Treasuries and investment grade bonds despite today’s low yields.

What is a low yield? If it is 1980 and you get 12% but inflation is 10% then you got a real rate of 2% and paid 4 percentage points of your 12% yield in taxes, assuming a 33% tax rate, thus your after-tax real yield was positive 2% minus 4% tax equals negative 2% real yield after-tax. Thus investors should not rebel against today’s low yields but should instead recognize reality and deal with it carefully rather than exploding with anger and rushing into buy the poorest quality junk bonds, etc.

Investors need independent financial advice about the danger of misunderstanding today’s “low” bond yields. Don’t jump from the frying pan into the fire. I wrote an article “Bonds did OK in high rate era but circumstances may change”.

About the author

Don Martin, CFP®

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