Investors Need to Pay Attention to the Ten Year Treasury Benchmark, a Possible Game Changer

The interest rate on ten year U.S. Treasury bonds is one of the most important benchmarks for investors. To a significant degree, it serves as a proxy for all domestic bond investments. Recent changes in that benchmark raise important issues for investment strategies going forward.

On May 31, 2012, the CNBC reported:

“The yield on the U.S. 10-year Treasury note fell to its lowest level on record Thursday, as continuing fears about some euro zone countries' ability to service their debt kept demand for U.S. fixed-income assets firm. Yields on 10-year notes sank as low as low of 1.572 percent on an intra-day basis.

The prior cycle low of 1.672 percent was originally set in February 1946 and matched in September, 2011. In short, the yield on the ten year is now lower than at any point in the past 100 years. This includes World War II, when interest rate caps were imposed by the federal government.”

The prudent investor must consider the implications of reaching this hallmark on their future investment strategy. During May, Treasury yields had posted nine straight weeks of declines, the longest run of weekly declines since a nine-week streak ending in October 1998. The yield on the ten year had fallen from 2.37% in mid-March to its current 1.57%.

The fall in the ten year Treasury yield is the continuation of a long mega-cycle of decline from the peak in September 1981 when the yield was 15.32%. The result has been a long bull run for Treasuries. The total average annual return (interest plus increased price appreciation) of an intermediate (7 to 10 year) U.S. bond fund has exceeded average stock market returns as measured by the S&P 500 since that 1981 peak. This 30 year period of ever decreasing yields and increasing price appreciation has established a deeply ingrained pattern of expectations by market participants and is presumably incorporated in investment/trading models.

The fall in rates on the ten year sovereign debt is not limited to the United States. The yield on ten year German bonds fell to 1.22% on May 31, the lowest since the German government began keeping records in 1959. Rates on ten year bonds issued by the United Kingdom also fell to record lows, while the rate on Japanese ten years stood at .82%. The primary driver for this collapse in rates is fear that Greece will default on its debt and undermine European financial institutions and Eurozone economies, potentially setting off a worldwide recession.

The yield on the ten year Treasury has now fallen below the annualized rate of inflation, which stood at 2.3% in the last report. This inversion which has occurred only a few limited times over the past 50 years (i.e. during 1946 and 1981) means the real rate of return on these ten year Treasuries is negative. In short, investors are willing to suffer a negative real return in exchange for the safety of these long government bonds.

Some prominent fixed income experts now predict the ten year rate will fall to 1.5% in coming months. It is now less than 1/10 of one percent above that level. A small number of bond bulls have suggested it could fall as low as 1%. By contrast, according to a Bloomberg’s May survey of key participants in the fixed income market, the ten year would end 2012 at a 2.48% rate.

The prudent macroeconomic investor will want to pay attention to the course of the ten year rate benchmark over the coming decade. Economic analysts have advanced three possible scenarios:

• Scenario 1: The ten year rate will remain in the 2% range for all or most of the decade. Under this scenario, growth will remain slow (less than 3%) and the inflation rate will remain subdued – in the 2% to 3% range experienced over most of the past decade. If this scenario were to occur, a current investor in an intermediate (7 to 10 year) U.S. government bond fund would receive less than 2% in annual interest payments and little or no appreciation in principal. Inflation adjusted, the investor would receive no or even a negative return.

• Scenario 2: The ten year will climb to the 4% to 5% range over the coming decade. The ten year hovered in that range for a decade between 1997 and 2007. This scenario assumes annual growth and inflation will be 3% or greater. The Fed and market participants would demand a real (inflation adjusted) return of at least 1%, especially given falling bond prices due to rising rates. The Federal Funds rate would be increased from its current level of 0.2% to at least 2%. Intermediate bond investors would receive higher interest payments but lower resulting principal. The total return for the intermediate Treasury bond investor would depend on the timing of the rate increases, but most likely would be no greater than the range of return projected under Scenario 1.

• Scenario 3: The ten year rate will climb to 5% plus. The assumption is that inflation will spike above the 4% range due to the huge increase in the world’s money supply following the recent financial crisis and further money printing by central banks in an effort to sustain economic growth. The Fed would be forced to significantly raise the Funds rate to counteract the inflation. This scenario further assumes that large government deficits would force rates up in order to attract buyers for the burgeoning supply of bonds. The increase in annual yield would offset most of the loss in principal, but the bottom line return would be comparable to the first two scenarios.

Under all three scenarios, the total return for benchmark Treasuries will likely be less in the coming decade than in the past quarter century due to the high likelihood that rates are at or near the cyclical bottom. Having fallen from 15.32% to 1.57%, there is little rate decline left in the cards. A rate below 1% seems unlikely. Increases in rates will reduce the price of bond principal which will be partially offset with higher yield payments. Over the next several years, total nominal returns on intermediate Treasuries are likely to be no more than 2% to 3% under any of these scenarios.

Prudent investors should adjust their expectations and allocations in light of this likely fundamental shift in the level and form of bond returns.

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Return to Part 1 of this Newsletter.

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