Andrew Sheets: The Impact of High Short-Term Yields

As short-term bond yields continue to rise, what impact does this comparatively high yield have on the broader market?

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, February 24th at 2 p.m. in London. 

One of the biggest stories brewing in the background of markets is the sharp rise in yields on safe, short-term bonds. A 6 month Treasury bill is a great example. In November of 2021, it yielded just 0.06%. Today, just 14 months later, it yields 5.1%, its highest yield since July of 2007. 

The rise in safe short-term yields is notable for its speed and severity, as the last 12 months have seen the fastest rise of these yields in over 40 years. But it also has broader investment implications. Higher yields on cash like instruments impact markets in three distinct ways, all of which reduce the incentive for investors to take market exposure. 

First and most simply, higher short term rates raise the bar for what a traditional investor needs to earn. If one can now get 5% yields holding short term government bonds over the next 12 months, how much more does the stock market, which is significantly more volatile, need to deliver in order to be relatively more appealing? 

Second, higher yields impact the carry for so-called leveraged investors. There is a significant amount of market activity that's done by investors who buy securities with borrowed money, the rate of which is often driven by short term yields. When short term yields are low, as they've been for much of the last 12 years, this borrowing to buy strategy is attractive. But with U.S. yields now elevated, this type of buyer is less incentivized to hold either U.S. stocks or bonds. 

Third, higher short term yields drive up the cost of buying assets in another market and hedging them back to your home currency. If you're an investor in, say, Japan, who wants to buy an asset in the U.S. but also wants to remove the risk of a large change in the exchange rate over the next year, the costs of removing that risk will be roughly the difference between 1 year yields in the US and 1 year yields in Japan. As 1 year yields in the U.S. have soared, the cost of this hedging has become a lot more expensive for these global investors, potentially reducing overseas demand for U.S. assets and driving this demand somewhere else. We think a market like Europe may be a relative beneficiary as hedging costs for U.S. assets rise. 

The fact that U.S. investors are being paid so well to hold cash-like exposure reduces the attractiveness of U.S. stocks and bonds. But this challenge isn't equal globally. Both inflation and the yield on short-term cash are much lower in Asia, which is one of several reasons why we think equities in Asia will outperform other global markets going forward. 

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