Long-Term Treasuries Just Logged Their Worst 5-Year Real Return in U.S. History

Long-term Treasuries have just posted their worst trailing five-year inflation-adjusted total return in U.S. history, according to an analysis by Mark Hulbert, a regular contributor to MarketWatch. That grim milestone, Hulbert argues, is precisely why bond investors shouldn't give up now.

The historical record, which Hulbert traces back to 1798, shows a pattern. In the four prior occasions since 1798 when bonds' trailing five-year real returns were nearly as bad as they are today, bonds' subsequent returns skyrocketed. Bond bear markets don't last forever, he notes, and some of bonds' most impressive gains have followed multi-year stretches of poor performance.

Hulbert is careful about the limits of that evidence. A sample of four episodes does not support statistically robust conclusions, he concedes. Still, it offers solace to beleaguered investors. Financial advisers tell him that many of their clients are tempted to throw in the towel.

Why does Hulbert expect a bond rally?

The stronger pillar of the bullish case sits in this year's move in inflation-adjusted Treasury yields — the gap between nominal yields and expected inflation. From the beginning of this year to its October high, the 10-year Treasury yield rose by 120 basis points, while expected 10-year inflation rose by just 38 basis points, according to the Cleveland Federal Reserve's inflation expectations model.

The arithmetic follows directly. Ten-year real interest rates rose by nearly a full percentage point this year, though they have eased back in recent weeks. The latest 10-year real yield now sits 1.6 percentage points above its long-term average.

That gap matters because of how real rates behave over time. Given real interest rates' marked tendency to regress to the mean, Hulbert writes, rates are likely to be significantly lower in the coming years. Lower rates, in turn, mean higher bond prices.

Does inflation really explain 2023's yield surge?

Hulbert challenges the traditional explanation for this year's rise in nominal rates. The standard story holds that nominal yields climbed more or less in lockstep with expected future inflation. But the data call that rationale into question: if nominal rates had risen in step with inflation expectations, real rates would have stayed steady. They didn't.

Instead, the bulk of the increase came from the real component — the part that historically reverts toward its average.

What if the Cleveland Fed model is wrong?

Skeptics have an obvious counterargument. If the Cleveland Fed's inflation expectations model is wrong, real rates may not be unusually high at all, and the bullish case for bonds would be a lot weaker. Some would push further, invoking Finance 101: when the market's judgment conflicts with an academic model, follow the market.

Hulbert doesn't buy it. The Cleveland Fed's model is not merely academic, he writes. It is market-based, relying on inputs such as:

• The break-even inflation rate — the yield difference between the 10-year Treasury and 10-year TIPS
• Inflation swaps — derivatives whose payoffs are tied to future inflation

The implication is pointed. The same investors who have driven nominal yields higher are also betting that inflation expectations have risen only modestly. The market's own inflation pricing, not just a spreadsheet, undercuts the idea that real rates are normal.

What's the bottom line for investors?

Hulbert's conclusion is measured but firm: there are good reasons to expect bonds will perform much better in the coming year than they have over the past one. The case rests on two legs — a rare historical setup after the worst five-year real return on record, and a 10-year real yield sitting 1.6 percentage points above its long-term average with a documented tendency to mean-revert.

For investors weighing whether to abandon bonds after the worst stretch in U.S. history, Hulbert's message is that the darkest data points have often preceded the strongest rebounds.

Mark Hulbert's Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited.