Here at Elevate Wealth Advisory, one of the core beliefs of our investment philosophy is that market prices contain information. The information largely relates to expected returns across asset classes, but sometimes we can extract other signals from market prices, as well. This month we’ll try to unpack what the world’s largest bond market (U.S. government bonds) might be telling us.
The chart below depicts the U.S. Treasury “yield curve” as it looks today (in red) and how it looked one year ago (in blue). The curve shows yields on U.S. government bonds by maturity, from ultra-short-term (one month) to very long-term (30 years).
The first message that, in our opinion, jumps off this chart is “Yields are much higher today.” There has been a dramatic shift higher in rates across all maturities, particularly at the short end. We believe the reasons for this shift are two-fold: the sudden return of high inflation, and the efforts by the U.S. Federal Reserve to combat this inflation by raising overnight lending rates.
Higher rates are like a double-edged sword – negative for borrowers but positive for savers. Whereas short-term bond investors were earning next to nothing on one-year Treasury bonds last year, today those same bonds are yielding more than 3.5%. (Beginning yields are an excellent forecast of bond holder’s total returns.) Higher yields are good news for savers and risk-averse investors.
The second message comes from the shape of the curve. One year ago, the curve’s shape was more “normal” and gently sloped upward as the maturity lengthened. This makes intuitive sense – investors should demand a greater yield (return) for holding long-term bonds relative to short-term bonds. Long-term bonds are riskier and much more sensitive to unexpected changes in interest rates and inflation.
Note that one year ago (blue line), the bond market correctly perceived that interest rates would rise in the future. While the market may have underestimated the magnitude of future interest rate moves, it was correct about the direction of those moves, predicting that future rates would be about 2% higher than current rates.
Today’s curve (red line) is very flat by historical standards. The yield on a one-year bond is higher than the yields on 10-year and even 30-year bonds. The message is clear: long-term bond investors are not being compensated for taking on additional risk with higher yields, as they usually are. You don’t see this very often, and typically this only occurs when the Federal Reserve is raising interest rates aggressively on the short end. This is exactly what is happening today.
We also discern a fourth message from this shape – the market does not believe that higher rates will be here for very long. If it did, you’d see long-term rates at or above short-term rates. Instead, the market is suggesting that the “peak” in rates will come sometime in the next year–perhaps around 3.75% –and then begin to decline again toward 3.3% in the next several years.
Lastly, because bond yields contain both a “real return” and an “inflation expectation” component, this has implications for expected inflation as well. The rates embedded in today’s yield curve suggest that the high inflation rate we are experiencing now (+8.5% YOY) is expected to moderate fairly soon. This is confirmed by looking at yields on Treasury Inflation-Protected Securities, which depict a sharp decline in market expectations for future inflation to barely 2.5% in the next five years.
As evidence-based investors, we know that market prices are not always “perfect,” but they are the best guess among millions of market participants tasked with balancing risk and return. While borrowing rates are higher compared to a year ago, expected returns for bond investors are also higher than they’ve been in many years. Hopefully, the market is right about the direction of future inflation, as well.