5% Yields!
On February 17th the 1-year U.S. Treasury Bond surpassed a 5% yield – a potentially impactful milestone. This threshold is one that U.S. Treasury Bonds haven’t seen since pre-2008 and is a stunning 4 percentage point climb from one year ago. Moreover, it appears that they may not be done rising as both the 3 and 6-month U.S. Treasury Bonds have both joined the 5% (annualized) club. In this post we will examine why this level may have big implications for investment portfolios.
So, why does 5% matter? We would argue that 5% is an important milestone for two reasons. First, the direct impact is that U.S. Treasury Bond levels affect the value of assets. Second, rate levels affect expectations of future rate changes, which can in turn amplify the first effect.
Regarding direct impacts, 5% is not particularly noteworthy. However, rates continue to rise and higher rates should, in theory, lower the value of the stock market because it lowers the value of future cash flows and affects corporate profit margins. Moreover, rising rates should lower the value of bond investments as these investments price-adjust to remain competitive with the prevailing level of interest rates. Look no further than 2022 to see the rising rate impact at work. In 2022 the classic 60/40 portfolio (i.e., 60% stocks and 40% bonds) had one of its worst years ever. This impact is exactly what would be expected as these results coincided with one of the fastest increases in the Federal Funds Rate that we’ve ever seen. So, to the extent that rates keep rising, one may expect further pain for the stock and bond markets.
There are, of course, other secondary adverse repercussions to asset prices. For example, rising Treasury Bond yields affect consumer borrowing costs for things such as car loans and mortgages, which, generally lowers demand for these items and, typically lowers home values. These types of impacts can cascade into a recession as consumers spend less and business profits fall. Also, Federal Reserve Bank research shows that falling security prices (e.g., think falling home values and 401k values) tend to also reduce consumer spending to the detriment of the economy.
The indirect impacts of rising rates (i.e., market expectations) can be even more pernicious. And, it is here where the 5% level may be meaningful. When we talk about market expectations which involve future projections, we are bringing emotion into the equation. Emotion and investing don’t mix well, and this type of environment (i.e., rising levels of uncertainty) is where we can often find irrational selling. On the expectation front, hitting a big milestone like 5% has a reverberating effect as the press amplifies the message which shifts narratives. We are, in fact, seeing a narrative shift right now. Market expectations can be seen in the futures markets (i.e., securities that represent future transactions). Action there is noteworthy. Until recently, the market believed that the Federal Reserve Bank would make fewer rate increases than they implied. We now see a bit of panic creeping in as the market is now guessing that the Fed will make more rate increases than they have stated. This is a big shift in market expectations, and expectations are critical as they drive investment decisions. If the market begins to think that rates are going much higher (i.e., no end in sight), it could lead to a substantial sell-off in securities markets.
Our general belief is that we’re nearing the end of rates climbing for this cycle and that it’s likely a favorable time to be adding bond exposure and adding duration risk (i.e., longer-dated bonds that will appreciate with decreases in interest rates). We would anticipate continued challenges in equity markets as weaker balance sheet companies wrestle with higher borrowing costs. Bankruptcies are expected to rise after a very quiet decade. Asset class weightings and sector exposures are likely to be more critical than ever. Overall, 2023 is shaping up to be another interesting and challenging year. However, volatility creates an opportunity and we’re excited about the potential that lies ahead.