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Chained To A Drunken Dragon

What is the fair level of the risk-free, 10-year Treasury yield? The market response over the last six months has been ‘higher.’ But when is higher high enough? Whoever can confidently answer this question holds the golden key to asset valuations and investment decisions.

Conceptually, the 10-year Treasury yield must equate to the sum of three components: the expected GDP growth rate (in real terms, as usual), the expected inflation rate, and a term premium required to compensate investors for the risk of locking in money at a given rate in the long-term.

Logically, if the return on a risk-free investment (such as a 10-year Treasury bond) equals the expected nominal GDP growth rate over the long term (once investors are rendered indifferent between the long and short-term via the term premium.), the risk-free rate is appropriately set. It is neutral from a macroeconomic perspective since it removes any incentive to over- or underinvest, i.e., it is neither accommodating nor restrictive.

Assuming a long-term GDP growth rate of 2%, an inflation rate of 2% (i.e., a nominal GDP growth rate of 4%), and a term premium of 50bps results in a 10-year Treasury yield of about 4.5% for the U.S. of A.

Given its long-term characteristics, one would think that such a variable is relatively stable over time. Indeed, the long-term GDP growth potential is broadly known, inflation expectations remain well anchored, and the term premium should be reasonably constant. Therefore, the 10-year Treasury yield should be able to see through the short-term noise and provide a beacon for decision-making.

Et bien, non. The 10-year Treasury yield was below 3.5% only six months ago and is now close to 5%, 150bps higher after a 35bps jump this week only. The world is chained to a drunken dragon.

It is difficult to imagine that the compound annual nominal GDP growth rate over the next decade has been revised by 150bps since Q2 unless one makes wild assumptions about the power of artificial intelligence. Therefore, the term premium, driven by investor preferences and whims, must explain the rise in the 10-year Treasury yield.

Historically, the ten-year term premium was between 50bps and 250bps. It fell below zero in 2016 and only became positive again this summer. It is a fickle parameter and a source of financial instability. Nothing) can explain its evolution convincingly. And don’t bother checking the behavioral pattern of the 30-year Treasury yield; it is not different.

If the term premium decided to revert to historical levels, the long-term risk-free interest rate could rise further to 6%, with dire implications for valuation multiples. Indeed, investors would struggle to assume that such a level is justified by a higher compound annual nominal GDP growth rate to 2034. Of course, the long-term risk-free yield could as easily move back to 4% and change.

Corporate financiers would do well to acknowledge this source of uncertainty and proceed with prudence when valuing assets.

The scary truth is that the risk-free yield is a high-risk variable.

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