Holders of long-term Treasury bonds, through an ETF or otherwise, accept the risk of the business cycle. When the economy booms, money becomes scarce and lenders ask for higher interest rates. But when the economy is in recession, capital is cheap, so borrowers ask for lower rates. Since the financial crisis, the U.S. economy has enjoyed a decade of steady recovery. So, in theory, long-term bondholders should have lost quite a lot of money. Instead, they have profited greatly. Why is this?
This week’s chart, inspired by a very interesting article by John Cochrane and Torsten Slok of Deutsche Bank, shows the gap between the 10-year Treasury bond yield and its forward curve.
To illustrate the impact this would have, consider the example of a person who invested in a 10-year bond. The bond is priced by the yield (black line) and the forward curve (red line), which illustrates discount rates of the bond at future dates. For example, the investor profits if the yield is lower than the forward rate one year later, because the bond was undervalued at the time of purchase. Therefore, with few exceptions, the forward rate has almost always overestimated to the realized 10-year yield since the crisis.
But the most telling feature of the chart is the slope of the forward curve. Right before the crisis, forward curves were very flat. This indicated that the market expected little upside potential in the business cycle, giving the bond the lower risk premium. After the crisis, the slopes steepened, meaning that the market expected an economic recovery.
Finally, notice the change in direction of the yield after 2016. As soon as the yield moved upward, the forward rate became very flat, somewhat similar to the curve in 2006.
How can this phenomenon be explained? Possibly due to the markets underestimating secular disinflationary forces, similar to the Japanese experience. It could also be a result of global quantitative easing and extremely low short-term rates suppressing long-term Treasury yields. The economy could also be weaker than most forecasters think, so the market quickly changed its expectation about the upward potential as soon as the yield took off.
Since the financial crisis, the market has provided opportunity to invest profitably in the long-term Treasury bonds. However, the forward curve has flattened over the past two years, potentially tarnishing the benefits of the business cycle risk premium. While long-term bondholders should remain cautious, a patient Fed and slowdown of the world economy may extend the window of opportunity to invest.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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