Something happened last week that hasn’t happened in a very long time. There were no parades or fireworks, but for people who follow the bond market it was very big news.
The event that made headlines was the yield on the 10-year U.S. Treasury Note rising to 5%. The 10-year Treasury is a global interest rate benchmark and it hadn’t hit that level since July 2007, just before the global financial crisis kicked into high gear.
In the years following the crisis, interest rates marched ever lower before finally bottoming out during the pandemic at near zero. Then, the world changed.
The resurgence of inflation in 2022 forced central banks to rapidly increase rates, sending bond prices into a tailspin. (Bond prices and yields move inversely.) By year-end, the U.S. bond and stock markets had both registered double-digit declines, a rare occurrence in financial market history.
Contrary to predictions from many market observers, interest rates have continued to rise this year. Along with a decline in stocks in recent weeks, the falling bond market at a time of geopolitical turmoil in the Middle East and elsewhere has made for a gloomy autumn for investors.
We can’t predict the future course of inflation, interest rates or world events. However, we can say with confidence that the market volatility of the last couple of years has produced important long-term benefits for those who are retired or are saving for retirement.
For the first time in many years, government bonds are offering a higher interest rate than expected inflation. The 10-year U.S. Treasury was recently trading at 4.9%1 while inflation was at 3.7% year over year in September2.
Another way to gauge available real returns is to look at government-issued inflation protected bonds. In Canada, long-term Real Return Bonds are yielding 2%, a level not seen since 2008. Again, this means you can lock in a government guaranteed return of 2% above the prevailing inflation rate for the long term. (Although with the U.S. deficit climbing to $1.7 trillion this year, the riskiness of U.S. government securities is open for debate).
So, the outlook for earning decent returns from bond investments has become much brighter, but what about stocks? Here, the news is also good if we’re guided by history.
The Credit Suisse Global Investment Yearbook draws lessons from a database of asset returns from 35 countries dating back to 1900. One of the observations in the 2023 edition of the yearbook is that when real returns on bonds are strong, equities tend to provide an even stronger real return over the subsequent five years.
The market declines we’ve endured during the last couple of years have been painful, but they’ve also left us with markets in a much healthier condition. After many years of abnormally low interest rates, they’re back to where they used to be before the financial crisis and that points to a future where investors will be able to meet their financial goals with less risk. And for those willing to bear the risk of stock market volatility, which is never easy in times like this, the returns are likely to be even greater.
1Market Watch
2CBC