Also, the yield on the 10-year Treasury note was over 6% 15 years ago versus roughly 2% today, making the risk premium of stocks versus bonds much higher today than it was then. Of course, none of this is to say a bear market can’t occur, but overall, a healthy earnings environment has kept valuations from approaching the levels that marked the peak back in 2000.
Market Realist – Risk premium increased as Treasury yields dipped
The above graph shows the yield on ten-year U.S. Treasuries (IEF) over the last 15 years. The yield has been dipping since the financial crisis. It dipped initially since the economy was deteriorating. That increases the demand for safe havens such as U.S. Treasuries (TLT) and gold (GLD).
After the financial crisis, yields remained low due to the Fed’s monetary accommodation. It currently stands at 2.0%.
In any investment, you get rewarded for taking returns. The lower the risk, the lower the returns. Hence, there’s always a trade-off between risk and return.
The yield on Treasuries is considered a risk-free investment since they’re backed by the US government. The risk premium calculates the amount of compensation the investor needs for taking on risk, or above that of a risk-free asset.
Assuming that stock returns remain constant, which is a big if, then indeed the risk premium will have widened, and it will imply that investors are demanding higher returns. However, assuming that risk tolerance remains constant, then the risk premium should remain somewhat static, and stock returns will actually come down.
We may be facing an overall low return environment rather than an expanded risk premium environment. As the economy improves, risk tolerance improves, and the risk premium will contract. If that happens faster than rates rise, then returns will drop.
Read on to know what could act as a headwind for equities going forward.