Chas Craig
BridgeTower Media Newswires
“So, if you don’t learn to constantly revise your earlier conclusions, and get better ones, you are – I always use the same metaphor – you’re like a one-legged man in an ass kicking contest.”
— Charlie Munger
Investors lamented the fact that 10-year U.S. Treasury Notes were yielding just 1.5% to start the year, which was a full 1% below market-based inflation expectations for the next decade. Now, the 10-year yields 3.8%, down from as high as 4.2% in recent weeks, a dramatic move higher throughout the year. As a result, the U.S. bond market (Bloomberg US Agg) is down 14% on the year, only slightly better (i.e., less bad) than the S&P 500’s 16% dive.
The graph of inflation adjusted 10-year constant maturity Treasury Securities covers a lot of the shoreline in describing why bonds have gone from plainly unattractive to reasonably attractive over the past year. In the graph, which can be retrieved from the St. Louis Fed at https:// fred.stlouisfed.org/series/DFII10, you see the real (i.e., inflation adjusted) yield on 10-year Treasury Notes back to 2003. Specifically, the 1.4% ending level shown in the graph is a result of reducing the current 3.8% yield on nominal Treasury Notes (i.e., regular Treasury Notes) by the 2.4% expectation for average inflation over the next decade embedded in the pricing of Treasury Inflation Protected Securities.
The graph breaks down into three distinct periods:
• Pre-Financial Crisis when real yields averaged around 2%.
• Post-Financial Crisis when real yields ranged between 0% and 1% under normal circumstances and had two extended periods (late-2011 to mid-2013 and early-2020 to early-2022) of negative real rates. These negative real rate periods mostly coincide with times when the Federal Reserve was engaging in quantitative easing with no publicly announced strategy to end those bond buying programs.
• The last period is since spring 2022, when real rates have gone from the unsatisfactory levels cited in the prior point to shooting through the 1% level that had served as a cap in the post-Financial Crisis era to now being at a level that nearly resembles normal pre-Financial Crisis.
So far, we have talked about bonds relative to their own history. Another way to think about the attractiveness of bonds is relative to stocks. Yardeni Research puts out a useful report entitled “Stock Market Briefing: Fed’s Stock Valuation Model Monthly/Weekly.” The most recent edition can be retrieved at https://www.yar deni.com/pub/valuationfed.pdf. Of particular interest is Figure 8 on Page 4, which compares investment-grade corporate bond yields to the earnings yield (inverse of P/E ratio) of the S&P 500 using Wall Street’s earnings estimates for the next 12 months.
The graph, which starts in 1979, has two distinct periods. Prior to the early-2000s was a period of attractive bond yields punctuated by the dot-com bubble, a time of uniquely unattractive stock valuations. During this first period the model suggested bonds were usually attractive relative to stocks. The second period is the past roughly 20 years when this model has almost always suggested that stocks were relatively attractive. While stocks still look mildly better through this lens, over the past year bonds’ relative appeal has gone from abysmal to the most attractive it has been in the post-Financial Crisis era.
Bottom line, the very low interest rates of recent memory have led many to conclude that bonds should be avoided. This is a conclusion worthy of revisitation for, while bonds are not obviously attractive, they are also not obviously unattractive.
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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).
