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An Uncomfortable Equilibrium
The fixed income markets are settling into an unstable and uncomfortable equilibrium, with several short-term trends looking likely to carry over into what looks like the medium term. A weaker U.S. dollar, a spike in gold price to all-time highs (in dollar terms), rising risk assets such as stocks and high yield bonds, rising inflation expectations—albeit from low levels–and, the biggest of them all, a fall to all-time lows in U.S. Treasury nominal yields, have translated to negative real yields. The idea that all these factors are all occurring simultaneously during a period where we’re seeing a large decline in volatility is concerning–or at the very least eye catching—and probably unsustainable. Accurate predictions as to the timing of changes with any market are always difficult, and this situation is no different. But while the timing may not be clear, I am dubious all of these trends can continue for the remainder of the year. While any one of these conditions could be the first to reverse, I will focus on the one nearest to my focus, which also is the one that appears to me to be the biggest outlier relative to the others—historically low nominal U.S. Treasury yields.
What do lower nominal bond yields mean to tell us when occurring simultaneously with a declining U.S. dollar, a spike in gold prices, a significant rally across risk markets, and a rise in inflation expectations? Well, if we listen to the pundits, it says nothing much, except that we should expect a continuation of the last decade's challenging and uninspiring economic backdrop. For all of these markets to have now achieved a “goldilocks” moment, it has required the major global central banks and the politicians that govern them to unleash a wave of either monetary and fiscal tools that has really never been seen before, or at least in my lifetime. It certainly is possible that it could all end well in some benign fashion. But I will argue that it is just as possible that it ends with a sharp reversal or reversals. Since it is so easy these days to find data that supports the negative, I suspect many will focus their views on the stock market and other risk markets as the likely area or areas for any looming reversal. While I agree that this is certainly possible, especially in light of the current economic environment presented by the COVID-19 pandemic, it appears to me that it is the U.S. Treasury market that is the largest outlier from a fundamental valuation perspective. As the charts nearby depict, once they are adjusted for inflation the 10-year U.S. Treasury note currently yields, in real terms, approximately a negative 1.20 percent. This level–while not completely unprecedented—is at an extreme and is difficult to reconcile in terms of a long-term expected rate of return. Lending to the U.S. government—while a fairly safe endeavor relative to other investable assets, at least today, at a level that results in an outright negative real return—is something investors should take issue with. Regardless, it is no grand bargain irrespective of one’s current assessment of global events. From a fundamental perspective, it is difficult to reconcile when considered against the other aforementioned market trends.
At the moment we are in a type of “goldilocks” environment where many different aspects of the major markets, fixed income and equity are positive. However, from my perspective the equilibrium state that we’re in now is unstable, and while it might not change until sometime in 2021, in my view this equilibrium state can’t last forever.
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