What's On Tap...

*Real* Treasury Yields

One of the more common conversation topics of market experts is the persistently low rate situation – especially at the longer end of the curve. The move down in longer term treasury rates actually accelerated following the December 2015 rate hike decision.  This unleashed a new wave of rhetoric around the dangers of such suppressed interest rates over time. Paradoxically, there is plenty of evidence to support the case that longer term rates are not (and have not been) influenced by the Fed since the beginning of the tech boom - this is probably no coincidence:

Source: Factset

Source: Factset

A significant amount of angst surrounds the fact that the 10 year yield has managed to make a new record low this year but looking at the yield in isolation to other factors can be misleading. Another common methodology is to compare these rates to measures of inflation. If we compare the 10 year benchmark with the All-Items CPI the picture changes dramatically – in fact, this measure of real rates has been rising for several years:

Source: FactSet

Source: FactSet

Despite the drop in interest rates, CPI has actually fallen faster. Some of the inflationary pressures have eased due to the precipitous drop in commodity prices – which has had far reaching impacts. It remains to be seen if it is a structural shift in the economy or a sign of a deeper economic slowdown ahead. Historically, inversion of the yield curve has aligned fairly well with recessionary periods as the market curbs expectations of future price increases. Right now, the trajectory is straight toward the zero mark:

Source: FactSet

Source: FactSet

Another curious perspective on the current and recent history of spreads is the relative degree to which investors have been rewarded for taking on longer maturity securities. From 1962 to 2007, investors received about 25% more yield for 9 more years of risk – a figure that boomed into near hyperbole following the initialization of QE and has since returned from stratospheric levels suspiciously around the time QE was terminated:

Source: FactSet

Source: FactSet

This last chart highlights exactly the way that QE was effective: It substantially, if artificially, increased the relative reward of holding longer maturity securities by a substantial factor.

The long term effects of such distortion remain to be seen, but now that QE is finished, the data indicates it is the economy driving long term interest rates. Until there is a sudden and massive realignment in economic expectations, it seems unlikely the decades-long trend in the Treasury market will change anytime soon. 

 

 
          William Royer, Portfolio Manager

          William Royer, Portfolio Manager

 

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