U.S. Treasury yields fell sharply in March when the Federal Reserve on March 18th said it would purchase Treasury securities as a means of anchoring interest rates in other parts of the U.S. bond market, in particular yields on mortgage-backed and corporate securities.
On the day of the Fed’s announcement, the U.S. 10-year fell from 3 percent to 2.5 percent. Ever since then, yields have been creeping higher, in large part because investors worldwide have become more willing to take risk. Many investors are responding to signs that the U.S. economy is contracting at a slower pace.
The popular argument for higher Treasury yields is based on three principle themes:
- Big U.S. budget deficits will require massive issuance of U.S. Treasurys
- Massive creation of money by the Federal Reserve will boost inflation
- Central banks worldwide want to diversify their portfolios out of U.S. dollars
Treasury Supply Not as Important as Other Factors
With respect to the first point, I have noted for quite some time and in my books that Treasury supply only matters in bear markets and the Treasury market is certainly not in a bear market. The behavior of the Treasury market is an example of the small influence that supply has over the behavior of yields. Bigger factors are fundamental, in particular the inflation rate and the cost of money, which is the federal funds rate, the rate set by the Fed. Both rates are at zero.
Over the past 20 years, the U.S. 10-year has traded 1.75 percentage points above the federal funds rate and 2.75 percentage points above the inflation rate, which means that with the U.S. 10-year trading close to 3%, its yield is not too low. These gauges push the supply factor into the background. I say this recognizing that the amount of Treasury supply this time around is so large that it must and will be a factor in shaping yields but that it won’t be as important as the role that the federal funds rate and the inflation rate play in valuing Treasurys. This will be the case so long as the world keeps holding dollars and the Fed keeps buying Treasurys. Supply will become a powerful force when investors are fully embracing risk, which will be a very slow process. This has begun to happen and is one reason why Treasurys will face a test.
On the second point, in considering inflation risks, it is important to remember that there are quite a large number of holes to fill in the U.S. credit system, which means that the Fed’s printing of money will mostly go to fill holes. Moreover, the Fed's exit plan for its quantitative strategy can be implemented quickly. High unemployment will also give the Fed time to withdraw liquidity and the speed at which the Fed can withdraw liquidity is fast. The timing is tricky, though, akin to walking a dog with a long leash.
The diversification theme I note above is an on-going theme dating back to 2002 when the world held 70% of its reserve assets in the U.S. dollar. Today that figure has fallen to 63%. Where are yields? Lower, of course. In other words, just because central banks reduce the proportion of dollars they hold this needn't influence yields much so long the diversification is gradual, which it is likely to be for the next two decades until China's economy and its bond market grow enough to house the world's reserve assets.
The Biggest Challenge for Treasurys
A fourth challenge to Treasurys could well be the strongest in the time ahead, chiefly a mild shift in risk attitudes. Already underway, risk taking will pick up steam if investors continue to feel the U.S. economy has reached a trough. This will likely be the case because production levels have been brought low relative to sales and this will compel companies to slow their rate of production cuts. Government stimulus programs and efforts to help the U.S. banking system add to the idea of a trough. This will pressure Treasurys, along with the factors I noted mentioned above.
The U.S. 10-year has stared down 3% a number of times over the past two months, most prominently on March 18th when the Fed announced its Treasury purchase program. For the 10-year, 3% is the Fed’s line in the sand but if investors become willing to take more risks, the 3% line will be crossed, albeit not significantly, because the Fed would likely step in to assure that its efforts to lower mortgage and corporate rates is not jeopardized.
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