Ten-year Treasury rates continue to stay at historic lows following the “Great Recession” of 2008. The prevailing sentiment is that rates will climb as the economy continues to recover. On the other hand, it is important to give this view a historical context. There have been times where long-term bond yields have remained below average for extended periods. An interesting graph appeared in the Enterprising Investor blog for the CFA Institute (“Three Charts that Will Rekindle Your Interest in Financial Market History” by William Ortell). My interest was in a graph of the historic yields of the Ten-year Treasury security.

Using data from Robert Shiller (2013 Nobel Memorial Prize winner in Economic Sciences), I constructed the graph at right of interest rates. Long-term bond rates averaged approximately 4.6% over the available history, which is magnified by the high inflationary environment of the 1970’s and 80’s. However, it is interesting to note that there was a 20-year period beginning in the 1930’s where rates stayed in the sub 3% range, which is where rates are today.

We must be wary of the chance that rates could remain low for a long time, and possibly go lower. Much will depend on the Fed’s actions and the overall economy.10-Year Bond Yields 10 14


We added TIPS (Treasury Inflation Protected Securities) to many of our client portfolios several years ago. We are now selling them out of client portfolios, as we no longer expect them to fulfill their intended purpose.

TIPS were created in the late 1990’s. Issued by the U.S. Treasury, they pay a low, fixed, nominal interest rate, plus each year the principal value is credited with an amount equal to the impact of inflation as measured by the Consumer Price Index. In essence, TIPS were designed as a way to lock in purchasing power, as the principal of the bond grew at the rate of inflation, and the interest payment provided some real, after-inflation, rate of return.

The Current Problem
The Federal Reserve implemented extraordinary measures to stimulate the economy in the wake of the financial crisis, and “real” interest rates have dropped below zero. These measures helped the U.S. economy avoid a deflationary spiral like Japan experienced over the past several years, but the current interest rate levels are not sustainable, as savers should expect a reward for foregoing immediate consumption, not the loss in purchasing power they are experiencing today.

As the Fed unwinds their measures, and the economy continues to recover, it is reasonable to expect interest rates to rise. One might expect some equilibrium state where short-term rates hover at or above the rate of inflation, and savers get a positive real rate of return.

In the current environment, the Fed has successfully pegged inflation expectations at about 2%, and the value of TIPS varies on changing expectations of Fed policy instead of inflation expectations. The markets try to guess when the Fed will allow real interest rates to rise back toward some equilibrium level. Since the change in value is not related to a change in inflation expectations, TIPS are not currently an effective hedge against inflation.

Compounding the problem is the fact that TIPS funds have a long average maturity, greater than the overall bond market. Since their change in value is now more sensitive to interest rate policy and changes in rates, they behave much like other long-term treasury bonds, and no longer provide the expected level of diversification in the bond portfolio.

TIPS no longer provide the portfolio benefit they were intended to provide. TIPS were originally expected to provide some protection from unexpected inflation. The Federal Reserve has acted aggressively since the financial crisis to stimulate the economy and avoid deflation. As a consequence of the Fed action, TIPS are now behaving like long-term treasury bonds, meaning their value is more sensitive to changes in interest rates. With inflation expectations seemingly under control, it does not make sense to endure the volatility of long-term treasury bond risk, particularly in the face of an expected rise in interest rates sometime in the future.


The indices in the chart at right, except for those of domestic large companiesEquity Market Returns over Periods Ending September 30, 2014 1, show that stocks in the third quarter gave back some of their recent gains. International stocks and those of domestic small companies were down over 5%; stocks traded in emerging markets and Real Estate Investment Trusts were down by a lesser amount. The results of domestic large company stocks (S&P 500) in recent periods stand out. It is not clear why and may be evidence of short-term irrational behavior. Whenever an investor allocates new funds to stocks for whatever reason, they seem to gravitate towards the S&P 500, which bids up the prices of those stocks and could account for the recent positive results.

Over the past ten years stocks have provided reasonable returns, with a diversified stock portfolio earning an annualized return in the neighborhood of 10%. However, as the chart shows, to achieve that return it was necessary to endure a good deal of variability not only in the total portfolio but also among the individual asset classes. No doubt, this variability is what is in store for the future.

Bond Markets
Bond returns reflect changes in yields which, as shown in the chart at right, were Yield Curves 9 13, 6 14 and 9 14fairly stable over the past quarter and year-to-date periods. Consequently, returns on Treasury securities were relatively flat. Credit spreads (the difference between yield on Treasury securities and the comparable corporate bonds) have narrowed in recent periods, which explain the better returns from corporate bonds.

The ten-year yield on inflation protected Treasury securities of 0.6%, while increasing slightly, remains low by historical standards, and has remained so even as the Fed has cut back on its Quantitative Easing program. This minimal response to the Fed’s “tapering” leads some to predict that yields at these levels are a “new normal.” I remain doubtful.

Quantitative Easing and Excess Reserves
Over the past five years the Fed, through its “Quantitative Easing,” has added to its balance sheet $4.0 trillion (that’s trillion with a “t”) in U.S. Treasury securities. This massive purchase of Treasury securities seems to have had less than the expected impact on either economic activity or inflation. Now, as the Fed is curtailing this program, it might be useful to look at why this is the case.

When the Fed buys a security, it credits banks’ reserves. Reserves provide funds for the bank to lend to consumers, businesses and governments and thereby spur economic activity. Banks have not been making loans with these excess reserves.

In general banks don’t hold excess reserves. Until 2008, the average level of excess reserves was in the neighborhood of $1.3 billion. However, these excess reserves started to climb as the Fed began to Treasury Securities on Fed's Balance Sheet and Excess Reserves 7 08 to 7 14purchase securities. Look at the accompanying chart that shows Treasury securities on the Fed balance sheet and excess bank reserves over the past five years. As the Fed’s holdings climbed from a modest amount in July 2008, excess bank reserves climbed essentially in lockstep. In the past five years the proceeds from the Fed’s purchases have been held by banks as excess reserves. While the Fed can provide funds to loan with the purchase of securities, if there is no demand for loans then the impact on economic activity or inflation may not be what is expected. Essentially, the Fed is “pushing on a string.”

Given the above, the purchase by the Fed of U.S. Treasury securities has, by and large, simply been added to banks’ excess reserves. Therefore, as it begins to sell its current holdings, it seems a good guess that banks will simply use their excess reserves to purchase these securities and the impact from the Fed’s “tapering” will not be a whole lot more significant than when it was making the massive purchases.