5% is fair but not yet a screaming buy
· Pietari Laurila
The US 10-year Treasury yield has reached 5%. Is that high, or could yields go higher still?
We can break a government bond yield into three building blocks:
inflation + real interest rate + term premium
First, bond investors need to be compensated for inflation. The Federal Reserve officially targets 2% inflation, but underlying inflation has recently been running closer to 3%. Going forward, an inflation assumption of 2.5–3% appears reasonable.
The second component is the real short-term interest rate — ‘real’ meaning the interest rate above inflation.
The real rate is determined by the balance between saving and investment in the economy. It depends on many factors, including economic growth, demographics, private investment demand, global savings and capital flows, and preferences for saving.
The New York Fed estimates that the neutral real rate should currently be in the 1–1.5% range. Add this to 2.5–3% inflation and we get a neutral short-term interest rate of 4–4.5%.
But this is not the whole story.
10-year bonds are more volatile than short-term bonds, so investors normally demand additional compensation for holding them. This is called the term premium.
A New York Fed model currently estimates the 10-year Treasury term premium at 0.8%.
That gives us a simple way of thinking about today's yield:
2.5–3% inflation + 1–1.5% real rate + 0.8% term premium = roughly 5%.
This suggests that today's 5% yield is not obviously excessive.
The biggest uncertainty is probably the fair level of the term premium.
It was unusually low for much of the past 15 years. Inflation was low and relatively stable, while central banks bought huge quantities of government bonds.
Today, inflation is less predictable, governments are issuing much more debt, and bonds may no longer provide the same portfolio protection they did in the low-inflation era.
This argues for a higher term premium.
If it increased from 0.8% today towards 2%, the 10-year Treasury yield could approach 6%.
That would, in my view, represent a more attractive level than today's 5%.
5% looks fair and somewhat interesting, but not yet a screaming buy.