Risky Business: What the 10-year Treasury Rates Are Telling Us About the Market

If you’ve been following me on my blog, you know that I am a pretty risk-averse person. I hate losing money and even worse, feeling like I’ve lost control over it. Unfortunately, my protective habits meant that I missed out on one of the strongest bull markets in history.

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. ​​

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.

What can this chart also tell us?

The 10-year Treasury yield not only tells us a lot about what is happening today, but what we should potentially look out for in the future. While no one can predict the direction of the market or the economy, the 10-year Treasury can provide some valuable insights on what we could see in the coming months and even years. 

Let's take a closer look at what the historical and current 10-year Treasury yield is telling us today. 
​

1. We should adjust our expectations of future market returns

Returns for the stock market, bond market, real estate, and other market assets are all relative to the 10-year Treasury yield. Think about it this way - how much more risk would you be willing to take to earn a return higher than the risk-free rate? 

This is what is referred to as a “risk premium”, i.e. the difference between the expected return and risk-free rate in exchange for taking on added risk. 

The average return on the S&P 500 has historically been 10%, or ~7-8% when adjusted for inflation. However, these returns have been against the backdrop of a 10-year Treasury yield trend that has never dipped below 1%.

Now that the 10-year Treasury yield is <1%, the bar has been significantly lowered. Companies and sponsors looking to raise capital do not need to offer as high of a return to attract investors since the risk-free rate is so low. 

When we look at historical returns for indices like the S&P 500 as a means to predict future returns, we need to factor in the higher risk-free rate. If the yields on the 10-year Treasury remain low, future returns over the next few years may look lackluster in comparison to past decades. 
​

2. The 4% Safe Withdrawal Rate May No Longer Be The Rule of Thumb

If your investment portfolio is a source of passive income or cash flow, you may want to revisit your withdrawal rates given the outlook on future returns. 

Many proponents of the FIRE movement and retirees follow the 4% withdrawal rule, based on the work of William Bengen that was then popularized by the Trinity Study in 1998. This study determined that the annual safe withdrawal rate for a diversified portfolio of stocks and bonds was 4% in the first year and subsequently adjusted for the inflation rate each year thereafter. 

This data however was based on the performance of portfolios with various stock & bond allocations from 1925-1995. During this time frame, the 10-year Treasury never dipped below 2%. 

Now that the 10-year Treasury yield is below 1%, we’re entering unchartered territory. If the market can lower their risk premiums and thus market returns based on a lower 10-year Treasury yield, a 4% withdrawal rate may require riskier bets or could increase the chance that you dip into your principal. 

If you’ve planned your income around the 4% withdrawal rate from your investment portfolio, the 10-year Treasury yield is something you'll want to monitor more closely. 

3. There’s value in the wisdom of the market

The Federal Reserve makes its best effort to stabilize the economy through monetary policy. But even the Fed doesn’t always get things right. 

Despite the Fed’s announcement last month that they would let inflation run hotter than normal, 10-year Treasury yields haven’t budged. If the market believed inflation was on the horizon, we would expect to see yields rise as well.

​Given that the Fed has missed its target of a 2% inflation rate over the past few years, the market may have less confidence that inflation will indeed run higher as they hope or that it will last for an extended period of time. 

The Fed has done a commendable job managing the economy through the pandemic. But constantly predicting the future is hard. While we should always seek to understand the Fed's policies to help guide us in our investment decisions, the $100+ trillion bond market, made  thousands of domestic and international investors, sometimes knows better. 

​Since the 10-year Treasury yields are driven by the market, we can use it as an indicator of market sentiment around inflation and the health of the economy. 

Don’t just look back, look forward

After a monumental market rebound this year following a decade-long bull market, it has been easy to build more confidence and higher expectations around market returns. 

The 10-year Treasury yield tells us a potentially different story though that we should pay close attention to over the next few months and even years. With yields below 1% for the first time in history, we’re entering unchartered territory that could bring us more sluggish growth if this trend continues. 

The good news for Millennials and young professionals is that time is on our side. We can stand to take more risks and ride out a few rough years.

Investing is still a key component towards achieving financial independence. Inflation, even at its lower rates, is too strong of a force to ignore. Using an automated investment platform or robo-advisor can help ensure you maintain a diversified portfolio and manage your risk appropriately. I personally use Wealthfront to manage my investments. 

Keep calm, always be looking at what’s ahead, and continue to invest on! 

Tweet