treasuries, inflation, and stocks

Treasuries barely give inflation-adjusted returns. To the extent that they fall short of inflation rates, they cannot be called risk-free in its fullest sense. There is the consolation that it happened only twice in the past 18 years, in 2011 and 2012; but not much because there is another evil called tax. Excess of post tax return from treasuries over inflation is the real return earned by investors. That is why treasuries or any other fixed currency investments are not attractive over the long run. Also, they carry reinvestment risks unless you find zero-coupons. Yet for all practical purposes, they are indeed risk-free. 

And they do track inflation rates; well, sort of. Prior to 2008, things were not that bad; I mean things were normal. 10-year treasuries yielded 5.24% in 2000; they were 4.10% in 2007 just matching the inflation rate. Everything changed in 2008 reacting to the financial crisis, and never recovered completely since then. Long term treasury bonds quoted 2.42% in 2008 and reminded us of 1954 when they were 2.51%. During both the years, inflation rates were nearly zero. The difference is that from 1955 onwards the treasury bond rates steadily increased thanks to the buoyant economy; and by 1979 they reached double digits. From 1985 onwards, bond rates started falling, and stood at 5.24% in 2000. 

Inflation was higher during the 1973-1981 period, and started cooling off subsequently. It was 3.44% in 2000; but by 2008, inflation came down to almost zero. In 2009 and 2010, both treasury and inflation rates started showing sparks, but that was it. In the last five years, interest rates have been less than 2.50%, and inflation has only moved to 2% in the last two years. 

As of now, both treasury bond and inflation rates have started moving upwards at 2.40% and 2.10% respectively. 

One of the reasons for the booming stock markets has been lower interest rates. When alternative opportunities are unable to exceed hurdle rates, investors look for greener pastures. What is greener than equities? If bond yields of 2.40% are not good enough for investors, they will continue to back equities. Dividends and buybacks are still better than these bond yields, and there is the added attraction of capital gains from stocks. Furthermore, there is also more buzz due to the revamp of the tax codes. Otherwise stock markets appear to be quite pricey. 

While the value of stocks is the present value of their cash flows discounted at the cost of equity, it will remain higher as long as interest rates remain lower. For 2018, two reasons will keep them afloat: higher earnings leading to higher cash flows, and lower interest rates. We don't know whether earnings will increase as they did in 2017. Fed's struggle with increasing inflation and thus interest rates has been rendered futile so far. Most of its tactics have led to the headline statements rather than being effective. Now the Fed is entering the new year with an intent to increase interest rates; and it appears to be more intense than before. Whether investors will shift to bonds from stocks is a matter of expectations, and only time will tell. 

The danger with the stock markets though is that stocks can fall abruptly without notice, caution, and reason. But that does not mean investors should throw all cash to yield only 2.40%. That said, I reckon some allocation to bonds is inevitable at all times; rather more so now.