Nervous equity investors trying to assess how much damage higher Treasury yields could cause their portfolio should watch 12 month US government bills closely and head for cover as yields approach 3.5%.
That is the conclusion of the authors of the Credit Suisse Global Investment Returns yearbook, who use one of the world’s longest continuous asset return databases to formulate their annual update.
'The margin by which equities are likely to outperform cash in future will be lower than the 118-year historical premium of 4.3% per year,' they noted in the 2018 edition published this week.
'Expected returns on all asset classes are likely to be low as the authors’ research shows that when real interest rates are low, as they are today, subsequent returns tend to be lower. Equities are still expected to double relative to cash over a 20-year period, [however].'
The 'risk-free' rate of return investors are able to earn from the safest holdings in US government debt are a key metric used to weigh the appeal of holding riskier, but often more rewarding, stocks.
The authors suggest this has fallen from from its longer term 4.3% to 3.5%, more recently, meaning that risk appetite may begin to deteriorate the closer we get.
That has weighed heavily on investors' minds this year, as it became increasingly clear the US economy was running hot, and that the Federal Reserve may be forced to lift interest rates more than previously expected in order to cool excessive growth rates.
Forecasters tracked by Reuters have pencilled in another rate rise this year to earlier expectations and now expect the base rate to hit 2.5% by the end of the 2018, versus a previous forecast of 2%.
The Credit Suisse researchers pointed out that valuations that are historically high and rates which still remain historically low are creating a very high hurdle for future growth expectations to beat.
While 3.5% might seem like a lofty target versus recent experience and the current 1.99% – the last time people got paid that much to lend money to the US government over a one year term was over a decade ago, in November 2007 – it has already moved up fast from its earlier lows.
After taking more than two years to climb from 0.45% to 1.22% the 1yUST benchmark bill has covered the same amount of territory in just the last five months.
That repricing has been given impetus in the last week as the US Treasury prepped a record volume of short-dated bonds, as the government sought to fill a deficit widened by last year’s tax cut.
More than $150 billion in borrowing dated between four weeks and six months was auctioned yesterday to muted demand. A parallel auction of £28 billion in two year borrowing drove the 2yUST benchmark yield from 2.1% to 2.26%, in the slow-moving world of bonds, a significant move.
Investors have also become nervous because the cost of longer term borrowing has increased much more slowly than the cost of short term borrowing, a phenomenon known as a bear flattening, often observed before an economic downturn.
Ultra-long dated 30 year US debt yields have increased from 3.04% to 3.1% in the last year, less than a quarter of the 0.45% move in ten year debt from 2.41% to 2.88% over the same period.
While the evidence indicates there is little-to-no danger of an immediate downturn in the global economy, that suggests bond markets have discounted some of the longer term growth potential it was previously prepared to pay for.