Monday, September 27, 2010
I haven't shown this chart for awhile, and in the meantime yields have fallen when I thought they would have risen. The colored "valuation zones" that I've added to the chart of 10-yr Treasury yields represent my guesstimate of the expectations/assumptions that underlie a given level of yield. Real investors determine the yield on 10-yr Treasuries, and they take into consideration a number of variables in coming to their decision to buy them. Chief among those is their outlook for economic growth and inflation, since those are the two variables that factor the most into the future course of the Fed funds rate. And the expected future course of the funds rate is ultimately the thing that most determines the level of the 10-yr Treasury yield. If the market expects growth to be very weak and inflation to be very low, the market will not expect the Fed to raise short-term interest rates for a long time. If the Fed stays on hold for many years, then a 10-yr Treasury yield of 2.5% looks very attractive relative to the expected return on staying in cash and earning almost nothing. That is the situation we find ourselves in today.
This is not to say, of course, that the market is always correct. I think one key to successful investing is identifying first what the market's assumptions are, and then deciding whether those assumptions could be wrong, and whether market pricing offers the investor attractive odds to "bet against" the market.
I knew that the market was expecting depression and deflation when yields fell to almost 2.0% at the end of 2009. That's because at the end of 2008, TIPS spreads were reflecting deflationary expectations, and corporate bond spreads were consistent with the assumption that as many as 50% of the companies in the U.S. would be out of business within the next several years. I had numerous posts in the fourth quarter of 2008 which expanded on the abysmal valuations and assumptions that were priced into the market at the time.
Today the market is revisiting the yield levels that we last saw near the end of 2008. There are some important differences this time around, however, which bear noting. For one, corporate credit spreads are an order of magnitude lower than they were in late 2008, which implies that the market currently is not expecting a depression, but rather something like a "double-dip" recession or a long period of agonizingly slow growth. Second, the implied volatility of equity and T-bond options is not nearly as high today as it was in late 2008, which suggests that the level of fear, doubt and uncertainty is much less. In a sense, the market seems more sure today that the economy will be very weak for a long time, whereas back then the market was terrified that we were headed over the edge of an abyss.
In my view, this means that the odds the market is offering to bet against it are not nearly as attractive today as they were in late 2008. Back then, you could make a fortune just betting that we weren't headed for the end of the world as we know it. Today, you need some amount of growth (which I'm guessing is 1-2% per year) and some positive inflation in order to make money.
Still, it seems to me that 10-yr Treasury yields are very low relative to the outlook implied by credit spreads and implied volatility. There is a disconnect, in other words, between Treasury yields and other key indicators of market valuation. Whether this makes Treasuries a bubble or not, I'm not sure. All I know is that if the economy grows 2% or more and inflation picks up just a little, it's not clear to me that the Fed will remain on hold indefinitely. That would challenge the market's current assumptions, and at the very least some holders of 10-yr Treasuries would likely get nervous and sell.
In order to like the idea of holding 10-yr Treasuries in your portfolio, in other words, you need to be quite sure that the economy is going nowhere for a long time, and that there are some lingering deflationary pressures out there which haven't been addressed by the Fed's $1 trillion injection of reserves into the banking system, or by the dollar's pervasive weakness against other currencies, commodity prices, and gold.
In short, the market is priced to some fairly pessimistic assumptions. I'm by nature an optimist, believing that free markets are a breeding ground for industrious people and new ideas that in turn lead to productivity gains and continually rising living standards. I'm also very encouraged by the sea change in the mood of the electorate—as reflected best in the astonishing appearance and rise of the Tea Party—and what this means for the future course of fiscal policy. Washington has been doing just about everything wrong for the past several years, and now there is reason to think that policy may get back on a more sensible and growth-generating track.
Posted by Scott Grannis at 6:37 PM