Contributed by Lewis J. Walker, CFP®
As reported in The Wall Street Journal, 7/2/16, on July 1, 2016, the yield on the benchmark 10-year U.S. Treasury note hit the “lowest level ever” at 1.385%. We underline the word ever to underscore the astounding fact that the yield on 10-year government paper has never been so low dating back to February, 1790. According to the Journal, in 1790 America began to accumulate debt to help pay Revolutionary War costs.
Ten-year paper closed at 1.446% at the end of the trading day on July 1, up from the intra-day low of 1.385%. Why is the 10-year Treasury yield so important? The Federal Reserve Bank sets short term interests rates, known as the “federal funds rate.” The current Fed Funds target rate is 0.25%-0.50%. This is the interest rate applicable when one depository bank lends funds held at the Federal Reserve to another bank overnight. This rate affects monetary and financial conditions. It is widely watched as a signal of Federal Reserve intentions, “easy money” versus “tight money,” with impacts on GDP growth, employment, and inflation.
The fed funds rate is one of our central bank’s levers, whereas the 10-year Treasury rate is influenced largely by market demand for Treasury paper coming from bond buyers worldwide, the so-called “bond vigilantes.” Whenever there is a flight to safety, such as during the 2-day Brexit market exit, buying pressure pushes bond prices up and yields down in inverse fashion.
The 10-year Treasury note rate has substantial influence on mortgage rates. The all-time peak for the 10-year Treasury rate was 15.82% in September, 1981, as Fed Chairman Paul Volcker pushed the fed funds rate to 20% to throttle inflation rates from the Jimmy Carter years. The prime lending rate for ordinary borrowers soared to 21.5% in December, 1980, compared to 3.50% today.
Older investors remember fondly getting high interest rates on savings in 1981. But it was a financial chimera. The inflation rate in 1980 was 13.5%, compared to core inflation today of 2.2%. The top federal marginal tax rate was 70%, versus 39.6% today. For a couple filing jointly in 1981, a 54% rate kicked in at $60,000 of taxable income, equivalent to $158,572 in 2016. For a single filer, $30,000, or $79,286 in today’s dollars. Hey, up-and-comers, how would you like to lose 54 cents of every marginal dollar earned to the federal tax man? You would “feel the Bern!”
So when “seasoned citizens” remember fat yields of yesteryear, after adjustments for taxes and inflation you were lucky to break even. Generally, you were behind the curve. Today, with inflation at 2.2%, after taxes you still are!
Brexit caused a flight to the U.S. dollar, pushing down yields on federal paper while strengthening the dollar. The theory is that Britain’s surprising decision would spur foreign central banks to create more easy money, while restraining the U.S. Fed from pushing up our interest rates. A “too strong” dollar pressures U.S. exporters as goods sold in dollars are expensive compared to goods and services sold in weaker currencies. Expect interest rates to stay historically low for some time. That’s good for borrowers, including home and vehicle buyers, if one can qualify for a loan. The Journal reported 15-year fixed mortgages at 2.77%. Essentially, that’s “free money” adjusted for inflation and taxation. Homeowners, check your current rate. A “no cost” re-fi could put dollars in your pocket!
Savers will continue to shop for “safe money” yields. For the week ending July 1, the average bank money market yield was 0.27%. That’s ridiculous, and many mainstream banks pay less that that! See bankrate.com. You can find FDIC-guaranteed rates at 1.00% and better.
As an investor you can do better in the search for cash flow, if you are willing to accept non-guarantees and some degree of volatility. Your adviser can help explain the trade-offs between safety and yield. Yields on well-selected value oriented stocks can range from 2%-3%. Yields on certain real estate plays offer the potential for good yields and an inflation hedge, and in some cases, tax shelter from depreciation.
We live in a nervous, low-yield world. Yin and yang offers challenges and opportunities. Understanding the tradeoffs is integral to financial success!
Lewis Walker is a financial planning and investment strategist at Capital Insight Group; 770-441-2603. Securities and advisory services offered through The Strategic Financial Alliance, Inc. (SFA). Lewis Walker is a registered representative and investment adviser representative of SFA which is otherwise unaffiliated with Capital Insight Group.