This is a guest post (part 1 in a 3-part series) by Sam, author of Financial Samurai, “How to Engineer Your Layoff,” and founder of the Yakezie Network. Part 2 is A primer on the most important economic metric (part 2) and Part 3 is A primer on the most important economic metric (part 3).
Finance and investing don’t have to be complicated. Consistently buying low and selling high can make you rich beyond your wildest dreams. Of course, if investing were so easy, we would all be kicking back and letting our money work for us instead of slaving away at the office every day.
When I started working on Wall Street in 1999, it felt like I was drinking from a fire hydrant because I was inundated with financial metrics. As a good institutional equities salesman, I should know the latest GDP forecasts to get a grasp of the overall macro momentum of the country. I’d then need to be able to speak eloquently about inflation expectations to differentiate between real and nominal growth. Finally, I’d have to drill down to a stock’s specific sales, operating profit, net profit, and margin assumptions to figure out whether the company was a buy or sell.
After a couple years of what felt like groping in the dark, pretending like I knew more than I really did, I finally found one metric that was more powerful than the rest. By studying this one metric thoroughly, I was able to confidently talk to investment professionals 20 years my senior in a reasonably intelligent manner. I dare say that this one simple metric encapsulates almost everything there is to know about finance.
I’m not going to promise you after reading this series of articles that you will suddenly become an investing guru. What I will say is that hopefully this article will help you see the financial world with anti-glare, polarized lenses. By seeing things more clearly, you can drastically improve your chances of making profitable investments. With more profitable investments, it’s only a matter of time before you achieve your financial goals.
Introducing the 10-year Treasury yield
The 10-year Treasury yield is the yield on a U.S. government Treasury bond. The U.S. government regularly issues Treasury bonds to raise money to help fund the national budget. In case you don’t know, the U.S. budget has been in a massive deficit of $1 trillion-plus for the past five years. Only in 2013 are we actually forecasted to see a deficit below $1 trillion, thanks to economic growth, increased tax receipts and slightly lower spending.
As of August 2013, the largest holders of U.S. Treasuries by country are China, Japan, Brazil, Taiwan, and Switzerland, according to treasury.gov. Foreigners buy U.S. debt as a way to diversify their own investments as well as to recycle the proceeds they receive from their exports to America, such as, Chinese-made toys sold in the U.S.
The 10-year Treasury yield is also known as the risk-free rate. Why? The reason is because the U.S. government is considered the most solvent, credit-worthy country in the world, despite running a massive budget deficit, and in spite of the recent debacle on Capitol Hill. Just ask yourself whether you’d feel better buying a U.S. government bond or a North Korean government bond. Surely you would choose the former.
Part of the reason why U.S. Treasuries are so safe is because the U.S. dollar is a world currency which is also artificially manipulated by America’s ability to print money. There’s virtually no chance the U.S. will default on its debt because, when things get tough, the Treasury department can always print more money to pay off debt. When things get really tough around the world, foreign money buys even more U.S. debt. Without the printing press, faith in the U.S.D and U.S. assets would wane, leading to a massive depreciation of U.S. assets.
Now that we know the sanctity of U.S. Treasuries, we can dissect what goes into the latest 10-year Treasury yield which changes every single trading day.
What the Treasury yield tells us
Some of you might be skeptical about the power of one single metric, but please give me a chance to explain what the latest 10-year U.S. Treasury yield means for your investments and for your personal finances. Let’s run through assumptions based on a 10-year yield at 2.7 percent.
Opportunity cost: Given you can make a 2.7 percent annual return doing nothing with no risk, your investments had better provide a return greater than the risk-free rate of return due to risk. This 2.7 percent return is close to an all-time low — 1.6 percent was the low reached in the fall of 2012. In other words, your hurdle rate is also close to an all-time low, making the alternative — equities — much more attractive than if the risk-free rate was 10 percent.
When the risk-free rate fell below 2 percent, smart money was flooding into equities because the S&P 500 dividend yield alone was over 2 percent. With cheap valuations based on historical levels and a 2 percent market dividend yield, the risk/reward was to the upside for buying stocks and selling bonds at all-time highs. One should generally always look to buy stocks when the stock market dividend yield is greater than the 10-year bond yield. The same thing goes for buying CDs when their yields are higher than Treasury yields as well.
Inflation expectations. Everything is Yin Yang when it comes to finance. Interest rates rise due to the expectation of higher inflation and fall when there is an expectation of low inflation. With a 2.7 percent Treasury yield, we know that U.S. inflation is therefore no greater than 2.7 percent because nobody will buy a bond with a 10-year duration if it provides a negative real rate of return.
To illustrate, let’s say the Consumer Price Index (CPI) is currently at 4 percent. If you buy a 2.7 percent yielding bond, your real return would be negative 1.3 percent (2.7 percent minus 4 percent) a year so long as inflation is at 4 percent! The only reason you would buy a 2.7 percent-yielding bond when inflation is at 4 percent is if you believe inflation will drop below 2.7 percent quickly or may even go negative as in a period of deflation. Deflation is a very difficult economic situation where the expectation of a decline in prices leads to further declines because nobody is willing to buy anything when they can wait for cheaper prices in the near future. Deflation is often feared most by the Federal Reserve, followed by hyper-inflation.
If you understand the 10-year Treasury yield, you have an idea, more or less, of where inflation expectations are at any time in history. In 1990, the 10-year Treasury yield was around 9 percent. That means inflation was running likely between 6 to 9 percent a year. Pretty neat, right?
It’s important to note that there is no inherent bad or good Treasury yield number. If Treasury yields are high, then asset inflation is high, which is good for asset holders and bad for price takers. When Treasury yields are low, asset-light investors are hurting less and should use this time to accumulate more assets.
Next time, I’ll discuss more about what the 10-year Treasury yield tells us and then take it further to explain how this can help you plan your investment decisions. But for the time being, go out and look at what the 10-year U.S. Treasury bond is doing these days and start to get familiar with this metric. Have fun out there!
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