The ten-year Treasury yield hit a seven-year high of 3.2% back in October as US stocks were surging and investors traded the safety of US Treasuries for riskier stocks. Things have changed a lot since then. The US-China trade war has caused a ripple effect, and it threatens to derail a bull market that’s not long in the tooth. The recent escalation of the trade war has sent economic growth estimates south.
As a result, investors have sought shelter in safe-havens like Treasuries. Yields are now as low as they were in the quantitative easing era earlier this decade. The Fed’s unprecedented ultra-loose monetary policy had driven yields very low. Currently, the ten-year Treasury is only around 30 basis points from its all-time low of 1.3% a few years ago. And the Fed’s current dovish stance will only support Treasuries.
A risk-off scenario could favor Treasuries
Meanwhile, for the longer term, things aren’t looking very attractive either. The 30-year US Treasury is currently trading at 2.17%, very close to its recent all-time lows. Yes, these yields look unpalatable. But yields could remain low for some time, especially if there’s no truce between the US and China. Both economies could cool down considerably, driving down inflation levels.
US equities and US Treasury prices have historically had a negative correlation. The graph above shows the relationship between the SPDR S&P 500 ETF (SPY) and the ten-year Treasury yield. For most of the last five years, yields have been moving in the same direction as the broad S&P 500 Index. The correlation between the two has stood at +0.62. In other words, stocks and bonds had a strong negative correlation in that period. Remember: bond yields and bond prices move in opposite directions.
With the recent volatility in stocks likely to last, Treasuries could be a good addition to a portfolio that lacks bond exposure. You can get exposure to the ten-year Treasury through the iShares 7-10 Year US Treasury ETF (IEF).
Negative sovereign bond yields could increase demand for Treasuries
Some other factors could drive yields lower. Sovereign bonds—especially in the developed world—are trading at much lower yields, even negative yields! The ten-year German bund yield is trading close to its all-time low of -0.59%. The equivalent Japanese bond is trading at -0.22%. Meanwhile, the ten-year Swiss government bond yield is even worse at -0.93%. So, although US Treasury yields are very low, they’re still attractive to investors looking for risk-free investments abroad.
The disparity should cause these investors to buy US Treasuries. This trend could drive US Treasury yields even lower. Note also that this trend could cause the US dollar to appreciate, which could be a headwind for another safe haven—gold.
Treasuries could still offer decent risk-adjusted returns
Meanwhile, though credit spreads aren’t the narrowest they’ve ever been, they’re narrow on a historical basis. Late in the economic cycle, credit spreads could expand—particularly if the economy gets worse. So, on a risk-adjusted basis, Treasuries could still offer some value to investors.
However, if—and that’s a big “if”—the trade situation improves, equities will get a nice bump, and US Treasury yields would back up quite a bit. At the moment, though, the scenario looks pretty bleak. Treasury bonds’ safe-haven alternatives are also trading at pricy valuations.