Let’s unpack what has been going on in the maligned bond market and where I think we are going from here because quite frankly, as an investment, I like where Treasury yields currently sit. I like them a lot, in fact.
The story has been in the term premium – the additional yield that investors demand to hold onto longer-duration securities. It reflects the inherent policy risks and uncertainty embedded in nominal bond yields that are not explained by the economy, inflation, or the Fed. The sort of things that are only explained by other factors.
At first, the surge in long-term yields reflected all the uncertainty surrounding trade and tariff policy, but that took a bit of a respite in mid-April when U.S. President Donald Trump offered olive branches with respect to the reprieves on the reciprocal tariff file. What then replaced that uncertainty was the fiscal risk premium embedded in the Treasury market as investors sensed that the White House and the Congress are bent on taking what already was an unsustainable budget path into a completely different orbit. A worry that, in my opinion, is way overblown.
The Treasury market term premium has spiked 60 basis points since early April to the highest level in 11 years and is now 100 basis points above the norm of the past decade.
It would be one thing if inflation expectations were surging. Another if growth expectations were surging. Neither are.
And consider this: only 15 other times back to the early 1960s has the term premium surged this much over a one-year time frame and this coincided with economic recessions more than half the time.
If not for the general policy uncertainty out of Washington, and now heightened fiscal risks, the 10-year T-note yield would be below 4 per cent at the current time, not 4.5 per cent, based on my reading from the breakdown of the interest rate structure.
Once a recession commences, yields will head back down but the fiscal largess will obviously limit the extent of the bond rally.
Still, a 5 per cent-plus long-term bond yield benchmarked against a 4.6-per-cent equity earnings yield (the market value of S&P 500 companies’ earnings divided by the S&P 500 index level) should be a bit of a no brainer for asset allocators. In the meantime, the 4.4-per-cent yield on three-month T-bills will serve as an attractive alternative and refuge and patience will be rewarded.
Now, a few bogeymen claims need to be addressed. First, the answer is no, the United States is not becoming some Banana Republic. The second answer again is no, there has been no evidence of there being some foreign buyers strike in U.S. Treasuries. The third answer is ‘no’ once again, this “Big Beautiful Bill” going through Congress is not at all economically stimulative.
There is no fiscal stimulus in this bill. It is restrictive – limiting economic activity and growth. It’s just not as restrictive as it could have been if the 2017 tax cuts had been allowed to expire at the end of the year, which would have thrown the economy over the fiscal cliff. The total deficit increase over 10 years is indeed just over US$3 trillion, including interest costs, but all of that sum and then some comes solely from cost of extending the tax cuts from 2017 for individuals and business. Together with all the program spending restraint, there is actually a NET DRAG on the economy of US$1.5 trillion or US$150-billion a year for the coming decade.
That is not “stimulus.”
I was amazed recently as the 10-year T-note yield approached 4.6 per cent that every tom, dick and harry economist and strategist were calling for it to retest the cycle highs. If you recall, the 10-year note last touched 5 per cent back on Oct. 19, 2023. But the conditions for the bond market could not be any different now compared to then. The funds rate is at 4.25 per cent, not 5.25 per cent, so the Treasury market naturally “carries” a lot better.
The year-over-year real GDP growth then was 3.2 per cent and the nominal trend was +5.9 per cent. Today, those numbers are +2.1 per cent and +4.7 per cent, respectively. The unemployment rate was 3.9 per cent then and is 4.2 per cent now. The industry capacity utilization rate was 78.3 per cent and today it is 77.7 per cent. The core inflation rate in October, 2023 was 4 per cent and now it is down to 2.8 per cent; the headline was 3.2 per cent and today at 2.3 per cent.
What am I missing with these outrageous views on the Treasury market?
And there’s something else. Back in the summer of 2020, when the 10-year T-note yield was trading at a miniscule 0.5-per-cent yield, you had no coupon protection at all. Since bond prices and yields move inversely, it would only take a 6-basis point increase in yield to erode your capital and send you into negative total return territory. Today, at around a 4.5-per-cent yield, the rate would have to surge 66 basis points, setting a new cycle high, for you to lose money in the 10-year Treasury note. Now that is a whole lot of coupon protection. But if for whatever reason, the yield were to go down to 66 basis points, to a level it was trading just last September, the total return would be close to 10 per cent. That is a trade-off that looks appealing to me.
For the anti-60/40 asset mix crowd, I posit that what makes the equity market different is that there is no such thing as coupon protection. There is dividend yield protection, but for that you need to be in the most boring defensive segments of the market (utilities, tobacco, food products and REITS come to mind) and resist the temptation of adding to the Mag Seven slice of the portfolio.
David Rosenberg is founder of Rosenberg Research.