Evening Brief – 05.17.23

It can be argued that the economic and inflationary patterns of the previous 30 years are likely to continue. High inflation and above-trend economic growth were produced by pandemic-related fiscal and monetary stimulus. Bond yields soared as a result, reaching highs not seen in fifteen years. They also ended the thirty-plus year downtrend.

But one may counter it on the grounds that current Treasury yields, which reflect the events of the last several years, are an anomaly rather than a new trend.

Investors buy bonds to boost their future purchasing power. Only by earning a yield higher than inflation can they reach that objective. Bond yields are thus mostly determined by economic activity and predicted inflation. As economic activity gravitates toward its natural rate of 1.5% to 2%, inflation and bond yields will likely follow.

Earning a long-term yield of 1.5% to 2% higher than the anticipated 10-year inflation rate will be a terrific bargain if pre-pandemic inflation levels return. Furthermore, even a small real yield that is positive (10-year yield less inflation) has been the exception rather than the rule over the past 15 years.

Despite obstacles that could prevent yields from falling (debt ceiling, post-debt ceiling issuance, QT), they can be overcome. Additionally, current yields are substantially higher than their recent lows if one assumes the economic and inflation trends of the past thirty years or more repeat. The 10-year yield was 0.50% just three years ago.

It’s vital to understand that not everyone who invests in long-term bonds holds them until they mature. Investors may sell the bonds, capitalize on the yield change, and reinvest the proceeds into a different asset class or even higher-yielding corporate bonds if rates recover to pre-pandemic levels.