US Treasuries are no longer risk free

US Treasuries are no longer risk free, but should investor’s ignore inflation and assume all is okay?

For those who adhere to Modern Portfolio Theory (MPT), this question must be a real thorn in their side. After all, Harry Markowitz, who pioneered MPT, probably never thought the US 10-year Treasury yield would ever be 1.42%! Unfortunately, it gets worse. Factoring in inflation, the real return is a staggering -4.58%, assuming 6% inflation. And I’m being conservative with the inflation numbers. Yikes!

Indeed, the entire yield curve is NEGATIVE. Simply put, there is no risk free rate available to accurately value risk assets. By the same token, if an investor views equities as too risky, are they to jump into US Treasuries and lock in a loss after inflation? Maybe over the short-term, but it’s suicide over the long-term. Surely, any portfolio manager who deems US Treasuries as a risk free asset won’t have a job for long.

The chart below illustrates the state we are in. There is nowhere to hide, negative real yields across the time spectrum.

The BEA Personal Consumption Expenditures Price Index is 4.1% as of October 2021, while the BLS Consumer Price Index sits a staggering 6.8%! For sure, I have not seen these levels of inflation in my lifetime. One thing is glaringly obvious, inflation is not transitory.

Conclusion

In the end, investors that rely on Modern Portfolio Theory to select securities need to adjust to the new paradigm. The days of hiding out in US Treasuries during bear markets is over. More likely, portfolio managers and traders will have to become more nimble, or be out of a job. That is, I expect parking capital in the US Treasury market for micro-short time periods will become standard operating procedure going forward. Of course, this will lead to higher levels of volatility, so take that into consideration when making investment decisions.

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