Chart of the Month – Lessons from the past

Which answer would you give to that question: “what is the most important event of the last 3 years for financial markets?”.

Many come to mind, like Covid, the war between Russia and Ukraine, the recent events in the Middle East, the hype around artificial intelligence, or the fake-start in the Chinese reopening expected boom, among other things.

I would personally give one and only one response: the 450+ basis points increase in US 10 year yields. Why so? Because this yield is the most important variable for all financial markets worldwide, as it is generally considered as the universal discounting factor.

This universal attribute makes sense: this is the yield you can obtain by investing in one of the most liquid and accessible assets, issued by the prevailing economic and military power, which is a democracy with an independent Central Bank.

The Chart of the Month illustrates the US 10 year yield evolution over a 55 years time frame. Shaded areas correspond to recessions.

What immediately strikes is the almost 40 years downtrend in yields, from 1982 to 2020, with a 0.30% historical low being touched during Covid. Another eye-popping fact is the very quick rise observed since then, as yields have nearly moved straightforward from 0.3% to 4.5-5%. Only twice in 55 years have US 10 year yields shot up by this magnitude, the previous occurrence being at the end of the 70s with the second oil shock.

Another easy conclusion is that the immense majority of market participants have always, at least until the end of 2020, acted in a falling yields environment, me included. This is not without consequences: falling yields provide a support to all financial assets and magnify valuations. They also help the economy by facilitating credit access and limiting debt servicing costs, hence less recessions. Incidentally, the chart shows that there were many more recessions when yields were rising or, at least, were much higher than during the post GFC era.

The big question is now the direction of this US 10 year yield; it seems highly unlikely that it will come back to the unprecedented lows of the past 5 years for many reasons, massive supply from the US Treasury being one of them. And this means that we are set to live in a completely different investment landscape going forward. If past is prologue, we should have a more volatile economy and assets valuations should feel the pressure of a higher discounting factor. It has started already: real estate is somewhat struggling; zombie companies are going underwater and credit accessibility is getting more challenging.

Contrarily to what prevailed during the last few years, interest rates should not provide the usual rescue to prop up asset prices for unprofitable or overvalued businesses. That is a big change, which should favour active management, and certainly jostle many investment habits.

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