Investors are focusing on the wrong 3% figure if they think the US bond yield is a cue for stocks to fall, says Lukas Daalder.
Yields on benchmark 10-year Treasuries rose above 3% in April for the first time since early 2014, prompting a lot of reactions that this may flag the end of the stock market rally. This is based on the notion that it triggers investors to dump riskier equities and enjoy the higher returns on super-safe US government bonds instead.
However, investors would do better to look at the short-term interest rate differential and currency risk between the US and Germany, which also stands at 3% and is a better guide to the real level of risk-adjusted returns, says Daalder, Chief Investment Officer of Robeco Investment Solutions.
“The talk of the town in financial markets this month has not been Trump, Korea, trade wars or even first-quarter earnings, but the 3% yield in 10-year Treasuries,” Daalder says. “Lo and behold, almost as soon as yields moved above the magical 3% level, US stocks started to move lower, ultimately surrendering 1.7% from the intraday peak on the first day.”
“This helped to strengthen the belief that bond yields have become an important indicator to watch, determining the fate of stocks moving forward. According to some, 3% is the point at which the pain threshold is getting too high for stocks to sustain current valuations.”
“So, is 3% indeed as important as some people claim? If we restrict ourselves to an historic assessment, the answer seems to be mostly ‘no’. Since 1990, US Treasuries have breached the 3% level to the upside on only four occasions, with stocks on average moving 6% higher in the two months that followed.”
“Another way to look at it is to see what level Treasury yields stood at when a stock market rally stalled. In the period 1998-2000, US 10-year yields rose from a starting point of somewhat over 4% to a level north of 6% before stocks buckled. In 2008, yields had been moving in a trading range of 4.5-5% when the correction in stocks began in earnest. Back in those days, 3% was considered to be an unattainably low level, and certainly not a barrier for stocks.”
Daalder says another myth is that inflation pushes nominal yields higher. “This turns out to be wrong: in both previous cases, core inflation fluctuated within a 2-2.5% bandwidth, while core inflation currently stands at 2.1%,” he says. “The US stock market – and in fact the US economy at large – continued to perform pretty strongly, with a real rate (nominal rate minus core inflation) higher than 4% in 2000 and above 2% in 2008; the current real rate is still below 1%.”
“Based on these previous episodes, it is clear that there is no pre-set level at which bond yields become a drag on stocks. The 3% figure seems to be little more than a nice round number posing no particular threat to equities.”
So, should investors ignore this market legend? “Certainly not, but we think that the focus has been on the wrong part of the bond market,” Daalder says. “Whereas everyone seems to be very much focused on the absolute level of the 10-year Treasury yield (the 3% figure), the much more important development has been on the short-term interest rate differential, which, in the case of the US versus Germany also happens to be around 3%.”
“This is important because this is the part of the yield curve that determines the costs/benefits that you get while hedging your currency risk. Say we’re comparing German Bunds, which currently yield 0.6%, with US Treasuries, which now yield 3.0%. At face value, the US market looks more interesting, offering a much better yield.”
“However, the problem is that most bond investors are not willing to accept the currency risks involved with owning foreign assets, and so they hedge their currency exposure, usually using something like a rolling one-year FX contract. By doing so, short-term interest differentials enter the fray. Two years ago, this differential was almost zero across the whole of the developed world, but things have clearly changed since then.”
“In the US, the Federal Reserve has pushed short-term rates steadily higher, while the bond-buying program of the ECB has pushed short-term yields in the Eurozone into negative territory, de facto pushing the interest rate differential to its highest level in three decades. For a European investor, the cost to hedge the currency risk has now risen to around 3% on a yearly basis.”
“Therefore, buying a US Treasury and hedging the currency risk renders a 0% starting yield. Given the flatness of the US yield curve, this is not a very interesting trade to set up right now. For a US investor, the opposite is true: hedging European FX currently yields a premium of 3% on a yearly basis. Buying a German Bund (or better still an Italian BTP) and hedging the FX offers you a starting yield of 3.6%, as well as a much steeper yield curve.”
“All in all, we get the feeling that the focus on the bond market is currently on the wrong 3%: it is not the 3% Treasury yield that should be dominating the headlines, but rather the 3% currency hedging cost/premium, as this is starting to have some serious implications for developments in financial markets.”
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