Are U.S. Treasuries Undervalued?

Are U.S. Treasuries undervalued? That might sound like an absurd question if you consider: the 10-year Note has a yield of not far above 2% and the 30-year bond is yielding just less than 3%; the Federal Reserve (Fed) is in the middle of a tightening cycle that involves both raising interest rates and soon, perhaps, curtailing reinvestment of its massive balance sheet.  Even if yields returned to their early 2014 levels, they would be 90 basis points (bps) higher on 10-year notes and 115 bps higher on 30-year bonds. 

So, can a case be made that U.S. Treasuries are undervalued?  First, compared to their equivalent in other developed economies, U.S. Treasuries remain among the highest yielding, especially among AAA-composite rated bonds.  Second, despite an eight-year equity bull market, U.S. Treasuries have performed decently for investors, and have exhibited negative correlations to equity markets during that time.  Third, as equities continue to rise, they are decoupling from corporate earnings, which might signal either a period of higher volatility or eventually lead to a sharp correction/bear market that could generate a massive flight to quality towards Treasuries.  Fourth, corporate bonds are also trading splendidly and represent a less attractive alternative than in the past.  Lastly, it is not just U.S. Treasuries that might represent good value: options on U.S. Treasuries are trading near historic lows and could also be in for a bull market if volatility increases.

Expensive Outright but Relatively Cheap

U.S. Treasuries are historically expensive but by no means at their priciest levels.  10-year yields fell below 1.40% in 2013 and 2016 while 30-year yields fell as low as 2.10% in 2016.  Compared to their foreign peers, however, U.S. Treasuries don’t look bad at all (Figure 1).

U.S. 10-year and 30-year yield about 80 bps more than their Canadian equivalent, 115 bps more than U.K. Gilts, 190 bps more than German Bunds and over 200 bps more than Japanese Government Bonds. German Bunds, in particular, have had a magnificent performance over the past two decades if one reinvested the proceeds (Figure 2), but one must wonder how this could possibly continue in the coming decade given that 10-year Bunds yield less than 0.30%.  

Figure 1: U.S. Bonds Historically Expensive and Relatively Cheap.

Figure 2: Bunds Have Generated Great Performance but Can It Last?

One counter argument is that the slope of the U.S. yield curve is very similar to those of its peers.  This is undeniable.  A large part of the reason why U.S. rates are higher is because the Fed’s policy rate is higher than that of the European Central Bank (ECB) and of the central banks of Japan, England and Canada (Figure 3).  As such, in terms of carry and roll down, U.S. Treasuries are not necessarily superior to Bunds, Gilts or their Canadian equivalents.  That said, if something goes wrong, those central banks have little room to further ease interest rate policy.  The Fed has room and U.S. Treasuries have upside risks.

Figure 3: The U.S. Yield Curve is no Steeper Than Most but it has Shifted Higher.

An Eight-Year Bull Market Did Nothing to Hurt Bonds

If one had been told in March 2009, when the S&P 500® hit bottom at 666 points, that by 2017 it would be trading at over 2,400 points, one might have imagined that U.S. Treasuries would have been a poor investment over that time.  One would have been wrong.  Over that time, the S&P 500® returned 269% above the risk-free rate, with dividends reinvested on an annualized standard deviation of 15.9%.  10-year and 30-year Treasuries had lower realized volatility levels of 5.5% and 10.3%, respectively.  When scaled up to the same risk level as the S&P 500®, something easily accomplished through futures, 10-year bonds offered a 98% return above risk-free securities while 30-year bonds returned 61% over the risk-free rate (Figure 4).  

While bond returns paled in comparison to those of equity indices since stocks hit bottom on March 9, 2009, the fact that they offered positive returns at all during the massive stock market rally is impressive.  What is more is that from March 2009 to June 2017, they offered not just positive returns but negative correlations with respect to the S&P 500®.  Since equities hit bottom, the correlation between Treasuries and the S&P 500® has averaged -0.39 for 10-years and -0.44 for 30-years. 

Figure 4:

Correlations are neither stable over time nor are they directly relevant to the question of whether Treasuries are undervalued.  They do, however, have indirect relevance.  Stocks are no longer cheap and have begun to decouple from corporate profits; they may become prime for a sharp correction over time.  Notice, for example, in Figure 5 that earnings peaked in 1997, three years before the ultimate peak in stocks in 2000.  The last three years of that equity bull market featured some big Treasury rallies, especially around the time of the Asian economic crisis in 1997 and the Russian default/Long-Term Capital Management (LCTM) debacle in August 1998.  The 1999-2000 tightening cycle wasn’t great for bonds but the 2000-2002 equity bear market was spectacular for bonds.  Likewise, earnings also peaked in early 2006, well ahead of the October 2007 peak in the S&P 500®.  The subsequent bear market was also great for holders of U.S. Treasuries.  Once again, earnings have decoupled from stocks.  Corporate earnings are no longer rising even as equity markets continue to rally. 

It does not mean that the equity rally will end tomorrow, but unless corporate earnings start growing it could be setting the stage for a period of higher volatility ­­– like in the late 1990s or in late 2006 and early 2007—with more frequent and violent corrections and bigger flight-to-quality moves.  Generally, declining corporate profits as a percentage of GDP have signaled a rise in volatility (Figure 6).  Eventually, a divergence between corporate profits and equity prices could set the stage for the next major bear market, which when it comes is likely to be a boon for bond investors, and those in the United States who, in contrast to their counterparts abroad, could enjoy substantial upside potential. The scenario for a bond rally has a heavy burden of assumptions, but the point is that there are risks in both directions.

Figure 5: Corporate Earnings and S&P 500 are Decoupling Once Again.

Figure 6: Falling Corporate Earnings Often Presage a Return of Volatility.

Corporate Bonds: Not an Overwhelmingly Attractive Alternative

At the height of the financial crisis in late 2008 and early 2009, junk bonds had yields of nearly 20% above U.S. Treasuries.  Those days are over.  Currently, they yield around 3.6% over Treasuries.  This doesn’t necessarily mean that the rally in high yield debt is over.  At the peak of the previous expansion in early 2007, high yield bonds yielded as little as 2.35% over Treasuries.  They achieved similar levels in 1998 before the LTCM meltdown (Figure 7).  As such, it’s possible that their spreads could tighten further to the benefit of the owners of high yield debt. 

That said, the Fed tightening and corporate profits no longer growing robustly probably are not great news for high yield debt in the years ahead.  If the equity market corrects, it will likely take the high yield market down with it.  High yield debt won’t offer great diversification from equities (but can, as we have pointed out in the past, be hedged with equity index futures to some extent).  In the event of an equity market correction, the loss to high yield bonds will likely be a gain for the holders of U.S. Treasuries.

Figure 7: High-Yield Spreads are Low but Not at Record Lows.

Even if equities and high yield bonds rally, U.S. Treasuries won’t necessarily be a terrible investment.  The past eight years have demonstrated that.  Moreover, the recent Fed tightening has dented but not derailed their returns. 

Would a Reduction in the Fed’s Balance Sheet Kill U.S. Treasuries?

Treasuries have done decently during the eight-year bull market in equities, but isn’t some of this due to the Fed’s Quantitative Easing (QE) programs, which have inflated its balance sheet from $900 billion before the economic crisis to $4.5 trillion today?  Indeed, a large portion of the QE expansion was achieved by having the central bank buy Treasuries, thereby taking them off the market.  If QE boosted the price of Treasuries, wouldn’t allowing that portfolio to dwindle by not fully reinvesting the principal of maturing bonds create a Treasury bear market?  Our answer is that it might and this constitutes a downside price risk for bonds. 

That said, if Treasury yields rise at some point, equity and high yield bond investors might look over their shoulders and ask themselves if it is worth taking the risk to hold stocks or junk bonds when they could find marginally more attractive yields in Treasuries than in the past.  The Fed’s balance sheet expansion probably benefitted the holders of risky assets more than the holders of (default) risk-free assets.  As such, a decline in the size of the Fed’s balance sheet might hold much greater risks to holders of high yield bonds and equities than it does to holders of U.S. Treasuries who would become the likely beneficiaries of any flight-to-quality.

Treasuries Options Could Also be Undervalued

It is not just the VIX volatility index that is trading near record lows.  The same is true for options on 5-year and 10-year U.S. Treasury futures, as well as options on Long Bond futures (Figure 8).  While the low levels of implied volatility are undoubtedly the result of a long period of very low realized volatility, this doesn’t mean that markets aren’t becoming complacent.  As the Fed continues to tighten policy and as corporate earnings fail to keep pace with the rally in the equity markets, risks to the system are likely to accumulate.  Add these monetary and financial concerns to the growing political risks around the world and one might imagine that we are setting the conditions for a bull market not just in U.S. Treasuries but also in options on Treasuries and, more generally, in implied volatility.

Figure 8:

Bottom Line

  • U.S. Treasury yields are historically low, and have the potential to move higher amid a tight labor market and a Fed tightening cycle.
  • Relative to their global peers, U.S. Treasuries are quite inexpensive.
  • U.S. Treasuries have performed well despite a 250%+ rise in equity market since March 2009.
  • U.S. Treasuries remain (most often) negatively correlated to stocks and could benefit from a flight to quality.
  • Both equities and high yield bonds have achieved high valuation levels and have decoupled from growth in corporate earnings.
  • A reduction in the Fed’s balance sheet does pose risks to the holders of Treasuries but they might be ultimate beneficiaries of a flight to quality stemming from monetary tightening.
  • Treasury options also look inexpensive and might be too complacent regarding upcoming risks.

About the Author

Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.

View more reports from Erik Norland, Executive Director and Senior Economist of CME Group.