Photo courtesy of el Floridita
Three months ago, in More Hemingway, Less Faulkner, I urged readers to consider the implications of rising risk-free rates. Though rarely credited, Hemingway conceived of the iceberg analogy, where what's unseen below the surface provides an immense structural foundation for success — underwater ice as the building block for what's above.
Business strategists have since adopted the metaphor, but to Hemingway, it was a visual blueprint for great literature: you don't tell the reader everything, and important details can be unsaid, yet knowable and structurally critical.
For investors, the rates of return on risk-free assets are the foundation for rates of return on risky assets.
A high-level framework for assessing any investment opportunity:
What could I earn without taking any risk instead?
Are the additional risks commensurate with the additional expected rewards?
When I published the piece in July, I focused on the risk-free rate for 1-year, measured by a U.S. government treasury bill. Such securities exist for other lengths of time, too, and all have different rates of return (yields).
Treasuries are, by definition, the only risk-free assets (anyone who claims otherwise is trying to sell you something).
The 1-year risk-free rate was then 2.98%. So at that time, if you had a 1-year time horizon until you wanted your investment back, and were exploring options, you should have demanded an expected return of higher than 2.98% to take any risk.
For context, at the same time the previous year...July, 2021...it was only .07%.
The return you could get on risk-free assets had increased by 4,257% in just one year.
The pattern existed across treasuries:
And if you think that's big, just wait.
In July, 2022, these risk-free rate yields all had a 2-handle. Now they all have a 4-handle.
A couple interpretations to help:
If you buy and hold a 5-year treasury for 5 years, the yield will be the 5-year risk-free rate. You will get 4.45% each year.
If you buy and hold a 3-month treasury for 3 months, the yield will be the 3-month risk-free rate. You will get 4.09% per year, or essentially just over 1% for 3 months...since your holding period is 3 months, not 1-year. You can then reinvest those proceeds into something else at that time.
Summarizing these risk-free yields over this time:
Now focusing only in 2022, the change from just three months ago:
If you're an investor who desires flexibility in the very near future, but also find these yields compelling, you probably prefer shorter-term treasuries. You prefer only being locked up for 1-year instead of 5-years, but also prefer 3-months to 1-year.
3-month treasuries are preferred by people who want to maximize optionality.
On reputation, Hemingway's interest in big-game hunting, bullfighting, regular fighting, and hyper-machismo living broadly defined...didn't scream great American writer.
But one characteristic did.
Charles Bukowsi. John Cheever. Truman Capote. Dorothy Parker. Tennessee Williams. William Faulkner. Raymond Chandler. Edgar Allen Poe.
A penchant for hard drinking.
In the early 1930's, while living in Havana, Cuba, and finishing "For Whom the Bell Tolls" — out walking one day, Hemingway stepped into el Floridita to use the bathroom, and noticed nearly everyone drinking daiquiris. He tried one, and had feedback:
I prefer it without the sugar, and double the rum.
This became his bar, and his drink.
Papa Doble, a.k.a. The Hemingway Daiquiri.
He once wrote to his friend, author Harvey Breit, that he drank 17 in a single day. It matters not because I expect you to also dislike sugar or prefer double rum. And I certainly don't expect (nor encourage) you to drink 17. For all I know, you may simply want one daiquiri, double the sugar, and no alcohol. And that's the point.
We all have unique tastes and preferences.
And the recent skyrocketing in risk-free rates is a great time to step back and recall our tastes and preferences as investors.
Since my last piece, in addition to the general increase across the board, one change really stands out:
3-month treasury yields have significantly closed the gap to other treasury yields.
Another way of describing this growth is that the 3-month's 4.09% yield is closer to the other current yields than its previous 2.41% yield was close to its counterparts previously.
Investors should determine if higher short-term riskless yields, and (now) VERY high relative short-term riskless yields, may play a role in their portfolio.
Furthermore, tuning out the economic and geopolitical noise, investors can conclude that no rational investor would invest in risky assets for an expected yield of anything less than the risk-free yield: the lowest expectation for the return of the stock market must at least be higher than the relevant treasury bill over the same period.
Reality can differ from expectation, but that doesn't change expectations (it just changes how you might incorporate them).
The toolbox for achieving great financial outcomes has changed quickly, as have the accompanying implications of these higher, risk-free, short-term rates. At the very least, you will have a better chance of success if you champion economic intuition over unfounded cocktail party, neighborly, and CNBC opinions about "where the market is headed" — there is no knowing, there are just probabilities.
And your own financial plan and investment strategy should stay updated and be informed by them. When the foundation of risk moves 4,257%, I'd argue we should pay attention.
I'm not telling you what to do, but I'm asking you to consider thinking this way.
From where we stand today, there is an updated menu. Better understanding how that menu may relate to your own portfolio intentions should enable better investor outcomes.
As such, orders will vary. There's no right answer — only tastes and preferences.
Papa Doble. Fortunes and frictions.