You Call That Easy Money, Huh? (Part 1)
This is part 1 of a 3-part series on where markets and the economy stand as we launch into the second half of 2023. We’ll talk about interest rates (part 1), the stock market (part 2), and the economic tapestry for it all (part 3).
Welcome to the back half of 2023. So far, the stock market has rallied into a new bull market after falling a good chunk in 2022, while the Federal Reserve has been pushing interest rates up for over a year to slow the economy and cool inflation. Maybe, just maybe, the Fed could soon be done raising rates, but the stock market’s rally so far has come as a confusing surprise to most. Then again, rallies are always experienced differently by different people:
The naïve optimist carelessly cheers the feel-good present moment, failing to recognize that investing is about successfully moving wealth across years, not days,
The thoughtful realist calmly welcomes the reward earned for risks taken, recognizing that markets are a venue for investors to accrue wealth over the long run despite a nasty tendency for near-term behavioral excesses,
The dogmatic pessimist calls every bit of good news a delusion, shakes his fist at the sunny sky, and drives ever tougher nails into his coffin-shaped bomb shelter.
It’s worth keeping one’s footing in the middle, since investing is a lot like living: it’s the tricky business of balancing warranted optimism with well-calibrated survival instincts. Many shades of gray, all worth taking in. Reflecting on the first six months of 2023, no two words seem to capture this palette of gray better than “easy money.” Depending on what the conversation focuses on, these words appear either reasonably descriptive or wholly deceptive. Let’s start by looking at the much higher rate of interest now available on US Treasury bills and bonds.
Interest on Tap.
A few weeks ago, as I was parking the car, Moriya walked into a charming little spot in Point Reyes, CA called the Tap Room. When she re-emerged minutes later, she handed me a cold fresh beer and delivered unexpected, good news: “They have Pliny on tap.” If you don’t know Pliny the Elder, it’s a cult California beer (often sold with a limit per customer), so imagine accidentally finding a shack on the marsh with Pliny flowing on tap at the end of a long day of driving.
For over a decade, earning interest on relatively low-risk securities, like US Treasuries, has been as elusive as that moment in Northern California. This has caused investors to do all sorts of scary things like “chasing yield.” But now, after a year of relentless interest-rate hikes, investors can earn over 5% on T-bills. Cash is no longer trash and there is honest interest on tap for anyone willing to manage a portfolio of relatively low-risk securities. This type of “easy money” doesn’t require you to “be right” (Too much in the realm of investing is predicated on being right about all sorts of things that are unknown and largely unknowable, making for a fool’s errand). It only requires commitment to pay attention to market prices and enough discipline to move funds around. When discipline fails, being motivated by the prospect of bank failures (hello, SVB!) can be a decent substitute.
To see how much the world has changed over the last year, look at the graph below. It shows interest rates on Treasury bills and bonds (which are exempt of state taxes, to boot) with maturities ranging from one month to thirty years. The blue line shows rates as of June 30, 2023, while the green line rolls the clock back a year to July 1, 2022 (The orange line shows where things stood three months ago, for good measure). The punchline is simple: All maturities are earning much higher rates, particularly short-term T-Bills (with maturities up to one year) that now earn over 5%.
Given this reality, investors are well served to explore a healthy mix of T-bills and T-bonds, balancing higher interest now versus somewhat lower interest for longer, and positioning for potential appreciation if or when the economy finally cools and the Fed returns to its rate-cutting ways.
Let’s Get Real.
Now let me introduce you to another type of bond issued by the US Treasury, which is worth a little bit of education, called TIPS (Treasury Inflation-Protected Securities). These are US Treasuries with a twist: They are marked up to make up for inflation. Setting aside complexities worth getting into elsewhere, the basic idea is simple. With regular Treasury bonds, you receive a known amount (call it $100) at maturity. What you don’t know is whether that $100 will buy you steak or hamburger meat, depending on how much inflation occurs between now and then. TIPS compensate you for inflation, causing economists to call them “real” bonds because they are effectively denominated in units of real consumption, as opposed to somewhat unreal US dollars. If it takes $120 at maturity to buy what $100 could buy you when those bonds were issued, you receive $120 at maturity. Pretty neat.
Because of this neat feature, TIPS earn lower rates of interest than regular Treasury bonds. Not so long ago, TIPS regularly earned negative yields (i.e., you paid for the privilege of lending to the US government), which didn’t make for a great deal, even though those were honest market-based prices. But now, TIPS are earning healthy yields, particularly the shorter-maturity ones. Take a look at the graph below. A year ago (green line), you could earn 0.25% on a 5-year TIPS; now the same maturity earns roughly 2%. That means that you earn 2% over inflation, no matter what happens over the next few years. That’s something and it’s there for the taking, no fancy footwork required.
To give you a sense of how unusual this is, look at the graph below (I promise, this is our last graph!), which takes all the real yields we’ve seen since 2000 and lines then up from low to high (the box marks the center of the distribution, from the 25th percentile on the left to the 75th percentile on the right). The red dot would read “You Are Here” if this were a hiking map.
All real yields are now outside of the “normal” range, but the 5-year TIPS yield stands out. At around 2%, it is in the top ten percent of yields going back to 2000, and that’s with compensation for inflation risk, making them worth a careful look.
We will dive into the stock market and the economy next time. But when focusing on interest rates, mid-2023 may indeed be a time where higher rates are finally making it easier for investors to move resources to the future with some reasonable degree of confidence and without having to rely on “chasing yield” into potentially riskier territory.