What Today’s Low Rates Could Signal for Your Portfolio

The world’s longest bull market in U.S. Treasuries is now well into its fourth decade. The 10-year Treasury yield was 14% in 1984 and is now just half of one percent.

For most of that time, dips in Treasury yields were a reliable indicator of economic weakness ahead. Today, that no longer seems to be the case. While there are certainly near-term market risks, including the pandemic, U.S. elections and global trade tensions, we believe we are in the midst of a V-shaped economic recovery. Improving growth in manufacturing, the service sector and employment are validating that thesis, yet the Treasury market so far seems to be ignoring improving growth. 

This has important ramifications for portfolio construction. First, long-term government bonds may no longer be the best option for yield or capital preservation with rates so low. Indeed, the “real” yield you stand to earn on a 10-year Treasury note is now negative one percent when inflation expectations of around 1.5% are factored in. Also, investors have grown accustomed to valuing equities based on their earnings potential relative to the yield on a Treasury. That method may not work as well going forward and could be fueling some of the excessive valuations we’re seeing now, especially in tech stocks.

Why are yields so low if the economy isn’t weighing them down? Unprecedented fiscal and monetary stimulus may point to the answer. Simply put, massive amounts of Fed bond buying to monetize all the newly created government debt is likely helping keep rates low. 

This may sound similar to what happened during the financial crisis in 2008 and 2009, but then the Fed increased its balance sheet by $3.6 trillion over two and a half years, not four months as it did this March through June. Another difference: Back then, banks held most of the new funds in reserves and consumers paid back debts, which kept growth low. Now banks are lending and consumers are saving, leading to the money supply increasing at a 24% annual rate. That would normally be a red flag for the kind of inflation pressure that would cause rates to rise.

Not this year. The Fed seems to be neutralizing interest rate pressure by providing forward guidance much further into the future than usual. It has signaled it is willing to keep bond yields anchored near zero for years, not quarters. We expect this aggressive guidance to continue at important Fed meetings coming up later this month.

Action by the Fed has so far proven effective at relieving the pandemic’s worst potential economic damage. That said, these policies can come at a cost. I’ve recently discussed high valuations in tech and other growth stocks. To this I’ll add apparent excessive risk-taking in corporate credit markets, the rapid appreciation of commodities like gold, and the depreciation of the U.S. dollar.

There is also potential for longer term interest rates to move higher if inflation expectations continue to rise. Investors should watch for a potential dip in gold prices, which could signal that real yields are set to bottom. Meantime, consider reducing exposure to long-term government bonds. For yield and capital preservation, intermediate municipal bonds may be a better option.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Aug 10, 2020, “Treasuries’ Cognitive Dissonance.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.