Celia Dallas
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Not in the United States. As short rates have increased and the yield curve has flattened, US T-bills offer more appeal than they have in some time (and short-dated Treasuries even more so). With nominal yields around 2%, real yields of T-bills are finally nearing positive territory, while two-year notes are firmly in the black. Although long-dated sovereign bonds will likely remain one of the best portfolio diversifiers in a recession, cash and short-maturity Treasuries offer important advantages in other situations.
First, the long end of the yield curve is very flat, and the market is pricing in just 26 basis points (bps) of yield increases over the next decade for the ten-year note—in contrast to the 34 bps of increases priced in over just the next year for the two-year note. Even a moderate 100 bp parallel increase in yields across the curve during the next year would see short-duration Treasuries outperform the ten-year by more than 600 bps (moves that size or larger have occurred in nearly one-third of annual periods historically). Second, should inflation expectations continue to increase, bonds and stocks could exhibit a positive correlation, increasing the appeal of short-duration Treasuries as a diversifier. Third, use of cash or short-duration bonds as a liquidity reserve in place of longer-dated bonds and liquid real assets allows for a higher portfolio allocation to equities and other risk assets while maintaining a comparable level of expected portfolio risk and return.
Inflation expectations have picked up modestly now that US core inflation is in line with the US Federal Reserve’s target of 2%. Expansionary fiscal policy, rising public debt levels, tightening labor conditions, higher oil prices, and a softer US dollar raise the specter that inflation could move higher. Nominal bonds have proven to be exceptional diversifiers of equity-heavy portfolios in recent decades, but any sustained increase in inflation expectations would surely test this. As expectations for low inflation became firmly anchored around the turn of the century, the diversification properties of Treasuries improved, with the ten-year US Treasury amazingly delivering positive real returns in 97% of rolling 12-month periods between 2000 and 2017 in which US stock returns were negative. By contrast, from 1968 to 1982, a period of high inflation expectations, ten-year Treasuries earned positive real returns during just 24% of negative 12-month stock returns, with cash outperforming ten-year Treasuries in 81% of such periods. Should long-term bonds falter in their portfolio-diversifier role, investors may find short-duration bonds to be more reliable.
From a portfolio construction perspective, an allocation to short-duration Treasuries can serve as an effective liquidity reserve under a variety of negative economic scenarios. Although they cannot provide outsized returns in the same way that long-term bonds, commodities, or natural resources equities can, they do provide exceptional stability across a variety of environments, permitting a smaller allocation to do the yeoman’s work of covering a couple of years of anticipated spending needs. Investors can build a barbell portfolio with a smaller allocation to short-duration bonds as the liquidity reserve and thus a higher allocation to risky, higher expected return assets. This barbell portfolio can be structured with similar risk and return characteristics to a more traditional portfolio incorporating a larger liquidity reserve focused on long-dated fixed income and liquid real assets.
We have long noted that predicting future interest rates moves is a fool’s errand, and for good reason—the experts have somehow managed to generate a worse-than-random track record of predicting even the direction of rates, much less their magnitude.* However, the flattening yield curve and prospects for rising inflation expectations do press the question of how likely it is that investors will continue to buy up an increasing supply of sovereign bonds without demanding yields materially higher than what are priced in today. As the Fed accumulates fewer bonds at the same time that the United States increases fiscal stimulus through tax cuts and increased spending, new-issue US Treasuries available to the private sector are set to increase by nearly $1 trillion this year and more than $1 trillion next year. This huge supply boost and stimulus are coming very late in the economic cycle when economic slack is quite limited. Prospects for inflationary pressure, along with a yield curve flat as a Kansas prairie, raise the appeal of US cash and short-dated bonds.
Celia Dallas is Chief Investment Strategist at Cambridge Associates
Originally published on May 8, 2018
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