Frozen Pension: What did low US Treasury yields ever do for us, anyway?

Whether you’re only now peaking out from behind the sofa or you’ve been investing passively like a trooper and refusing to look at your portfolio until Boxing Day, if you’re reading this site you’ve probably seen headlines implicating US bond yields in the recent assault and battery on the stock market.

For example:

Surging yields raise threat of tipping point for stocks – Wall Street Journal

Here’s why stock-market investors suddenly freaked out over rising bond yields – MarketWatch

Treasury yields are increasing again, reigniting concerns about higher rates in financial markets – CNBC

Are pundits in this game of financial Cluedo right to finger Mr Treasury Bond in the trading den with a cudgel as the villain?

As always – who knows. There are plenty of dodgy-looking drifters riding around stock market town at the moment and occasionally firing their guns into the air, from geopolitical tensions and rising oil prices to high valuations in the US and its trade spat with China.

Any of those other factors – and more, or perhaps nothing specific at all – could have been the trigger for what wasn’t a particularly large correction anyway, especially in America.

Investing nerds like me still debate what caused the huge 1987 crash. We can’t expect a definitive answer to what’s so far been a run of the mill wobble.

Higher rate hate

All that said, I suspect sharply rising Treasury yields are probably having an impact in various ways on the market.

In particular, the commentary from US central bankers that there may be several more rises to come seems to be vexing in some quarters.

Many of the same commentators and traders who chastised the US Federal Reserve for a decade for suppressing rates to record lows now seem happy to put the boot in again when rates are rising.

Given markets move on sentiment in the short-term, this sound and fury can make a difference.

The obvious question is why do rate rises matter, anyway?

After all, a US 10-year government bond is still only yielding a little over 3%. For almost all the post-World War 2 period, that would have been considered bargain basement.

Also, why should UK investors care? We’ve seen a couple of rate rises here, but our yields are still much lower than in the US.

Isn’t everything bigger in America? Why not the yield on the 10-year Treasury bond?

Alas, contrary to some wishful thinking in recent years, we do not live on a financial island in splendid isolation. Warren Buffett calls US government bond yields the gravity of financial markets, and we almost invariably feel the impact here of major developments there.

For example, the relative attractiveness of putting money in a US bank instead of a UK or European bank can move both our bond markets and our currency, by influencing the behaviour of massive and rootless capital flows. Money tends to go to where it’s treated best.

As for rising yields themselves, I’ve had a few queries about this both here and in the archetypal pub.

I’m certainly not a bond expert or a stock market historian – some of our readers are far more knowledgeable about the mechanics of the yield curve than me!

Nevertheless I did make a fair fist of explaining the potential issues arising from the prolonged low interest rate era back in late 2016.

It seemed to me then that Central Banks were ready to start closing the spigots on super-easy money. Politicians, too. I mused that they feared that the core business model of banking risked becoming unprofitable, with unpredictable knock-on affects.

I’m not sure that’s proven out, but the rate rises have certainly started, at least in the US and UK.¹

On the down low

Bond yields rising off the floor may matter to traders and analysts long before they are seen in costlier mortgages or over-indebted ‘zombie’ companies going bust.

As I wrote in my long piece:

A discounted cash flow model puts a discount on the future cash due. This reflects the uncertainty about future profits, as well as inflation and interest rates.

Normally, distant payouts are deeply discounted. But with the risk-free rate so low that doesn’t happen so much.

Why does this matter?

Because uncertain future forecasts have grown in importance compared to near-term cash flows. A discount rate of 2% doesn’t have much impact until you get far out.

This makes the present value of an asset even harder than usual to determine with confidence. Because future cash flows assume greater importance, the valuation is based on more finger-in-the-air guesswork.

It’s a nerdy-sounding but important point that may mean market valuations are wildly off. Even a modest rise in rates could cause a crash in all sorts of assets beyond what we’d expect.

I’ve heard a couple of people ask why technology shares that pay no dividend fell the most in last week’s kerfuffle.

Nobody owns those for income. Surely it should be utilities or ‘dividend stalwarts’ like Unilever and Johnson and Johnson that should be most marked down, if nervous investors believe they can now get the regular cashflows they require from bonds again?

That makes sense, and I do think the relative attractiveness of dividend-paying companies compared to government bonds will shift over time if rates keep rising.

But it’s the change in the discount rate that explains the theoretical shift in the valuation you’d put on say an ASOS or an Amazon, or even a Fevertree. The companies may rapidly start looking more expensive in an analyst’s model, even if nothing has changed in the business itself.²

Anyway, rather than rehash that article again here I’d suggest rereading those two previous pieces for more on how low yields may have distorted things in the past decade. Unwinding such distortions, where they exist, seems bound to have some impact.

Here are the links:

Understanding the low interest rate era

The problem with low interest rates

Also, if you tend to read Monevator via email or you don’t check back on the comments much, you will have missed the long thread that followed the latest Weekend Reading.

If you are feeling blue after a kicking that – incredibly enough – at one point had the FTSE 100 back at 1999 levels, you might at least find some comradeship in the thoughts of fellow readers.

(Thanks again for sharing all!)

The Federal Reserve further announced in late 2017 that it was beginning to reverse QE – what it calls ‘Policy Normalization’.
The more prosaic reason they fell farthest is that people dump pricey growth shares in times of panic!