Having done some research on the properties and history of the number three, nothing has pointed towards its hypnotic features. I will duly update Wikipedia to immortalise this point.
I am very puzzled by the level of attention that the US 10-year yield at 3% is receiving. I appreciate that it is a nice round number not seen for some time. But why should High Yield be concerned about 3.01% and relaxed about 2.87%, for example? In macroeconomic terms nothing has changed.
Chart 1 below shows the history of the 10-year US Treasury yield since 1962. Until the global financial crisis, 10-year yields never reached below 3%.
Chart 1: US 10-year yield history
The increase in US funding costs is relevant, but everything needs to be put into context – financial conditions may have been tightening, but very modestly and remain well below the recent peak, as shown in Chart 2.
Chart 2: US financial conditions
Aside from that, the US economy (unlike the UK) is much more exposed to long-term rates, in particular 30-year mortgages. At 4.5%, the Freddie Mac 30-year mortgage rate is simply back to its average over the 2007 to 2018 period, and well below the 5.25% average of the 2000 to 2018 period. From the trough (3.3% in November 2012), this level is just over 1% higher.
The bottom line is, the move in 10-year yields by itself has a limited impact on the US economy. Consumer confidence indicators are the highest they have been in 18 years – see Chart 3 – and that is despite uncertainty surrounding trade policies.
Chart 3: US consumer confidence index
But in broader terms should we be concerned?
There are certain areas that deserve attention in my view:
1. The dollar. Since the peak in December 2016, the US dollar has depreciated by 12%. Strong economic growth, higher commodity prices, ample amounts of liquidity and a weak dollar have created a very benign environment for dollar funding. This is particularly beneficial for emerging markets. The dollar has recently appreciated (see Chart 4) and if that was to continue it would be a concern (for me, more so than 10-year US Treasury yield).
Chart 4: Trade-weighted US dollar
2. Liquidity is vast, but less so than in previous years. The removal of policy accommodation is in motion. Central banks will not panic if volatility is higher, spreads are wider or equities are lower. A reappraisal of risk premiums will be welcomed by the US Federal Reserve. In other words, the ‘Powell put’ is nowhere near current levels.
3. Stock selection is becoming a key determinant of performance. What you do not own becomes as relevant as what you own. Holding companies that only exist thanks to central bank liquidity will be costly over the coming years.
4. The opportunity cost of owning equity or credit risk is no longer zero. US investors can invest in positive real yielding assets with little duration and credit risk. The yield grab in the US might unwind as safe haven assets become a consideration. If I was an US domiciled investor, Treasuries would certainly feature in my pension pot.
Summarising the above: we should be paying more attention to the evolution of the dollar and more broadly financial conditions. For now, nothing indicates that the end of the cycle is imminent (in fact the cycle is still young in Europe and in emerging markets) but the time of simply buying the highest yielding assets is behind us.