The financial crisis shook a lot of Millenials who were entering the job market or early in their careers. Having seen the aftermath of raging returns from the sidelines though, many came back with a vengeance when the market took a landslide in March 2020. Those who stomached the volatility and played their cards right were rewarded handsomely when the S&P 500 hit new all-time highs earlier this month.
With the dramatic shifts that Millennials like myself have experienced in the stock market during our adult lives, it’s safe to say now that our risk/reward compass could be a bit off-kilter. Recency bias is a strong force to be contended with when we’ve witnessed rock-bottom lows and climbed to all-time highs in the investment world.
Today, I’d like to discuss how risk-free assets can help us look forward so that we don’t let our cognitive biases get in the way of making educated decisions. Now that the markets have made a full recovery, it’s a good time to revisit our expectations on what we could potentially see in the future.
Predicting Investment Risk & Return Through the 10-Year Treasury Yield
While most investors have their eyes set on the stock market, one of the key indicators I also keep an eye on is the 10-year Treasury yield. The 10-year Treasury yield tells us a lot about market sentiment and what returns we can potentially anticipate on other investments and assets.
The 10-year Treasury note is considered a risk-free asset because there is very little risk that the US would default on its obligations. This is important to remember because the market yields of 10-year treasuries provide the baseline for risk and return premiums of other assets, such as stocks, bonds and real estate.
What is the 10-Year Treasury?
A 10-year Treasury note is a bond issued by the government that matures within a decade. These bonds are issued in $1,000 increments with a pre-specified amount of interest, called the “coupon yield”. When you purchase a 10-year treasury note, you are essentially providing a loan to the government in which they agree to pay you back in 10 years’ time at a specified interest rate.
The Federal Reserve auctions off 10-year Treasury notes to investment banks, who then offer them to investors on the secondary market.
When demand for the 10-year Treasury note is high, the price of these bonds increases as well. Since the interest (i.e. coupon yield) on these notes do not change though, a higher price effectively lowers the yields and therefore the return on the investment. Even if investors are getting a lower return though, it can still be worth it knowing that it is a safe asset.
Consequently, when demand is low, investors benefit from higher yields and therefore higher returns on their investments.
Demand for 10-year Treasury notes is highly correlated with the stock market and the economy. During a bull market or expansion of the economy, there are many other investments in the market that offer more attractive returns. Therefore, demand is typically lower for 10-year Treasury notes.
When the economy begins to contract or there is uncertainty in the market, investors tend to flee towards safer assets. As a result, demand for 10-year Treasury notes increases as investors begin allocating their money towards bonds.
The 10-year Treasury yield is also tightly connected with investors’ sentiment around inflation. Put another way, you would not want to invest your money in an asset that yielded a return lower than the inflation rate. When we see lower yields for the 10-year treasury, this means that investors may be less concerned about rising inflation rates in the future.
Now let’s take a look at the 10-year treasury yield over time.
Yields have continued to decrease over the past few years in line with lower inflation rates and, not surprisingly, plunged to all-time lows this year.
While investors are seeing dismal returns on the 10-year Treasury, one benefit has been lower interest rates on debt. Loans such as mortgages are also tied to the 10-year Treasury yields, which is why we've seen all-time lows on mortgage interest rates as well. For those who are trying to reduce their debt liabilities or are looking to leverage new debt, this is a great time to capitalize on the low interest rates we see today.