04 Mai 2018, 16:08 GMT
The ‘new normal’
The potential level of US economic growth will be lower in the future. That’s not new news; that’s the ‘new normal’ stemming from lower future labour force growth. But I mention it because the interest rate in equilibrium should be somewhat below potential GDP, which by my calculations puts the equilibrium interest rate at 3.25 per cent (fractionally higher than the Fed’s own estimate).
On average, the 10-year yield is about 0.75 per cent above the equilibrium interest rate. That means once interest rates have normalised in the US, we should expect a bond yield of about 4 per cent. So we’re now within 1 per cent of long term fair value.
Three per cent presents a buying opportunity
What makes me like treasuries with a 3 per cent yield is that we’re not at equilibrium levels of interest rate. Adopting my 0.75 per cent rule for the yield premium, I’d need to see the interest rate at 2.25 per cent and stay there over the next 10 years to make 3 per cent fair value for the bond yield. And I don’t believe that will occur. There’s not enough inflation; and there’s too big a chance of the economic cycle ending.
I said last December that a bad scenario for investors is an equity market driven down by higher bond yields. The most likely event to trigger that is high inflation, which could occur even if growth slows down from here. That tail risk can be covered by a purchase of emerging market index linked bonds, which are good value currently.
But I don’t view the lower equity and higher yields as likely. If we have a serious downturn in equity markets the Federal Reserve would (and now can) reduce interest rates and even recommence QE, which would lower yields. That would preserve the negative correlation between equities and bonds that we’ve enjoyed for many years.
Some investors have taken duration out of their bond portfolio, fearing higher yields; and consequently have lost that equity hedging asset in their portfolio. At a 3 per cent yield, it’s worth redressing that decision.
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