Update July 12. The yield on 10-year Treasuries rose to 1.52%, the highest level this month (and prices fell). Last week the yield on the 10-year Treasury hit a record low of 1.318%.
The climb in Treasury yields is likely to be temporary, in my opinion. The market is coping with a series of big auctions this week. An auction of three-year Treasuries on Monday attracted the weakest demand in seven year. Today an auction of $20 billion in U.S. Treasuries was the weakest demand since 2009.
The trend toward higher yields and lower bond prices isn’t limited to the United States. The yield on German 10-year bunds rose by 8 basis points to a negative 0.9%. Yields on the French 10-year bond climbed 7 basis points to 0.19%.
And the bond market faces intense competition for cash from a continued rally in U.S. stocks that had taken the Standard & Poor’s 500 stock index to 2154.70, a new all-time record, as of 3 p.m. New York time. The Dow Jones Industrial Average also hit a new all-time high today. When the S&P 500 is climbing 0.82% in a day, the argument for buying 10-year Treasuries yielding 1.52% gets a little weaker.
But the dynamics driving Treasury yields lower (and prices higher) in the longer term remain in place. At 1.52% for a Treasury and a negative 0.9% for a German bund, U.S.bonds have an immense relative yield advantage that’s likely to keep cash flowing into the U.S. bonds. And yields in Europe seem set to go lower. Deutsche Bahn today become the first non-financial company to sell a bond in euros with a negative yield. More than $3.3 trillion in European sovereign debt trades now with a yield below 0%.
Inflation expectations continue to fall. By the Federal Reserve’s preferred measure, inflation is now rising at just 0.9% annually. The bond market is now trading with expectations for just a 1.3% inflation rate in 2021-2026, according to Bloomberg. That’s the lowest level of implied 5-year inflation in Bloomberg data that stretches back to 1999.
The Brexit vote in favor of ending the United Kingdom’s membership in the European Union effectively took Federal Reserve interest rate increase off the table for July, and September, and November. And maybe even December. Remember that the process of exiting the European Union is a long one–and the two-year deadline for a departure doesn’t even get started until a U.K. government asks for an exit. We could still be in the scary, early, nobody knows what’s happening stages of an exit come December. (This post originally appeared on my subscription site JubakAM.com on Saturday June 25.)
And if a Federal Reserve interest rate increase is off the table for that long and global financial markets remain unsettled for that long and growth in the global and U.S. economy is going to be lower than projected just a month or so ago, I think it’s time to rethink exactly how low yields on the 10-year U.S Treasury can go.
The logic here is pretty simple. In an uncertain financial market investors and traders look for safety in assets such as Japanese government bonds, German bunds, and U.S. Treasuries.
As long as the threat of a Federal Reserve interest rate increase was a real danger, putting cash into Japanese government bonds and German bunds had a certain attractiveness over buying U.S. Treasuries. A hike in U.S. interest rates could send the price of existing Treasuries lower. The end of that threat from the Fed for the months ahead removes that disadvantage.
And that allows the big yield advantage of U.S. Treasuries to come to the fore. The yield on a ten-year U.S. Treasury was 1.56% as Friday, June 24. That compares to a negative 0.17% yield on the 10-year German bund and a negative 0.185% yield on the 10-year Japanese government bond.
If you are looking for safety and would actually like to make a little bit of money while you sit on near-cash, what do you think is more attractive right now? Collecting 1.56% in U.S. Treasuries or paying 0.17% or 0.185% to hold German or Japanese government bonds, respectively.
Which is why bond managers are forecasting a new drop in yields for U.S. Treasuries in the months ahead. Do remember that a drop in yield works out to an increase in the price of Treasuries.
The consensus among these Treasury bulls is that the yield on 10-year Treasuries is likely to drop to something like the 1.38% historic low of July 2012 or even further to a new historic low near 1.25%.
What would a drop to 1.38% or 1.25% from today’s 1.56% yield mean to bond prices–and the gains that bond buyers can think about?
If the yields on 10-year Treasuries fall to 1.38%, the price of a $1,000 Treasury bond would rise to $1130.44 for appreciation of 13.4%.
If the 10-year Treasury yield falls to 1.25%, the gain would be 24.8%.
Mind you I wouldn’t count on Treasury yields falling to match the historic low or to bust through that low to 1.25%. But it won’t take a drop all the way to those levels to make this a profitable position, especially when the U.S. and global economy look weak enough to keep returns from equities to very low levels.
You can, of course, buy Treasuries directly in the market or from the U.S. Treasury itself. And there’s no reason not to–the process is very easy. Or you can make it even simpler for a very modest fee by buying an ETF such as the iShares 7 to 10 year Treasury Bond ETF (IEF.) The expense ratio is a low 0.15%. For the year to date total return on this ETF is 7.06%, which certainly beats the 0.32% return for the Standard & Poor’s 500 stock index. Currently the ETF yields 1.58% and it pays dividends monthly.
I’m going to add this ETF to my Jubak Picks 12-18 month portfolio on Monday, June 27.
There’s increasing reason to believe that the Treasury market has stabilized on the fundamentals—until the next panic when the Federal Reserve again begins to talk as if a decision to taper off its program of buying $85 billion a month in Treasuries and mortgage-backed assets is just around the corner.
And if the Treasury market has stabilized, it means that the weakness in dividend stocks (calling it a sell off would be an overstatement) is at an end—for a while—too.
The latest piece of evidence comes from a Wall Street formula called the term premium, which measures the risk of holding long-term bonds by factoring in the market’s outlooks on inflation and economic growth.
If you assume that consumer inflation will continue for the rest of 2013 at something like the current low rate–the lowest rate since 2009; and if you assume that U.S. economic growth will stumble ahead for the rest of 2013 by something like 2% or so rather than “racing” ahead at 3%, then the current 10-year Treasury yield of 2.54% is about right.
The long-term reading on the term premium has been an average reading of 0.40% in the decade before the financial crisis in 2007. It’s now at 0.46%, according to Bloomberg. As recently as May 2013 the term premium was a negative 0.5%. The term premium has been in negative territory since October 2011 and turned positive only in June 2013.
What does all that mean? The term premium is the extra yield that investors require before they will buy a long-term bond instead of a series of short-term bonds. If, for example, the yield on a 10-year Treasury were 5.5% and holding a series of 1-year Treasury bills over the next 10 years would be expected to yield 5%, then the term premium would be 0.5 percentage points or 50 basis points.
In most periods you’d expect the term premium to be positive since investors would, normally, require extra yield to induce them to hold a longer-term bond. But under some circumstances the term premium would be negative. If, for example, investors wanted to lock in a long term yield instead of taking on the risk of rolling over shorter term bills—with the chance that interest rates might be lower on each subsequent roll over—then the term premium could well be negative. That is indeed why the term premium was negative in early 2013—bond buyers actually preferred locking up their money for the long term instead of taking the risk that short-term interest rates might fall for subsequent rollovers. It wasn’t necessarily that yields on 10-year Treasuries were so attractive in comparison to short-term yields. It’s just that they were preferable given the assumed unpredictability in short-term yields. Predictability is a valuable commodity for pension funds and insurance companies that want to match the timing of their cash outflows and the timing of their cash inflows.
The big reason that bond buyers have started to see 10-year Treasury bonds as fundamentally attractive again—aside from their big recent drop in price and rise in yields—is the absence of any signs of inflation. Look around the globe—can’t find it. Can’t even find a scenario that might produce it relatively soon. At current economic growth rates, the global economy is awash in capacity whether it’s capacity for manufactured goods or production capacity for commodities. With China’s economy slowing that global overcapacity doesn’t look likely to go away quickly. (The one exception to this pattern of modest inflation is, perhaps, food commodities but even there the potential for a record harvest this year has pushed down near-term prices.)
Real yield on the 10-year Treasury—that is the yield once you subtract current inflation—is 1.56 percentage points, the highest level since March 2011. As recently as November, real yields were negative.
This hasn’t been a great first half for Treasuries and other bonds. Treasuries, according to the Bank of America Merrill Lynch bond index, lost 2.48% in the first half of 2013, the biggest loss since 2009
But Wall Street now believes that bond prices have stabilized within a likely range for the 10-year Treasury of 2.4% to 2.8% for the rest of 2013. High levels of bond market volatility and the uncertainty over when the Fed might begin The Taper argue that bonds yields aren’t going back to former lows, however.
What does this mean to you? Read more
The Fed looks set to start adding to its balance sheet again: How will the bank ever exit without crashing the bond market?
I think the Federal Reserve is setting up investors for a significant change in policy to be announced after tomorrow’s, Wednesday, December 12, meeting of the Fed’s Open Market Committee.
The new plan would resume the rapid growth of the Fed’s balance sheet and push it to $3 trillion sometime in 2013.
And that just makes the big problem facing the Federal Reserve and the U.S. economy even bigger. After expanding its balance sheet by buying what will soon be an additional $2 trillion in debt to help stave off the worst effects of the global financial crisis and then to support a stumbling U.S. economy, how does the Fed shrink its balance sheet back to something like normal size without crashing the U.S. and global economies?
In other words Wednesday’s Fed meeting has huge implications for bonds, inflation, interest rates and how you structure your portfolio.
The Federal Reserve’s Operation Twist is scheduled to expire in December 2012. That program to swap about $270 billion in short-term Treasuries for longer-term, five- to seven- year debt to lower longer-term interest rates in order to support the recovery of the U.S. housing sector and to stimulate U.S. economic growth is almost certain to end with the year.
But Ben Bernanke and company are also almost certain to replace Operation Twist with a new, more aggressive program of quantitative easing. The Fed is clearly worried that the debate over the fiscal cliff alone or the actual expiration of all of the Bush tax cuts, the Social Security tax reduction, extended unemployment benefits, and the automatic budget cuts imposed by the debt ceiling deal will be enough to slow the U.S. economy and could even send the United States back into recession.
The new program, recent speeches by Federal Reserve governors and basic math argue, will be an out and out plan to buy five- to seven-year Treasuries. That would continue the thrust of Operation Twist but get around a big problem that the Fed now faces. It has become increasingly hard for the Federal Reserve to sell its short-term holdings of Treasuries and to buy medium-term debt to replace them because the Fed has effectively sold most of its short-term holdings. Since September 2011 the Federal Reserve has replaced $667 billion of short-term Treasuries on its balance sheet with medium-term debt. The Fed just doesn’t have much more short-term Treasuries to sell to balance its purchase of medium-term debt.
The new program will require the further expansion of the Federal Reserve’s already massively large balance sheet of $2.85 trillion as of November 21, 2012. That level has been relatively stable since June 2011.
But the new plan would change that. Read more
I think the argument that we’re in an income asset bubble is easy to make–deciding when it might burst and what to do about it are much harder
We are looking at a bubble in the market for income assets.
Money continues to pour into the government bonds of the United States, Japan, Germany and other “safe haven” countries even though yields there are negative after inflation and even though some of these “safe havens” rank among the world’s most indebted governments.
Dividend stocks too have risen to historic highs even as yields have dipped. For example, an index that tracks the Standard & Poor’s “dividend aristocrats,” a basket of 51 stocks that have increased their dividends annually for at least 25 years, hit an all-time high in October.
We all understand the reasons behind this love affair with income assets. Stocks have been scarily volatile for the last decade or more—and threaten to become even more so. The world’s central banks have flooded financial markets with cash, crushing yields, but at the same time promising to keep interest rates extraordinarily low for an extended period, in the formulation of the U.S. Federal Reserve. A sputtering global economy has resulted in low rates of inflation and frequently, in fact, deflation seems a more immediate threat than inflation.
But we know that we’re nearing the end of this cycle. The yield on two-year Treasury notes could drop below the current 0.24%–that’s a negative 1.96% yield at recent U.S. inflation rates—but the yield is unlikely to go below zero. At some point—mid-2015 in the Federal Reserve’s most recent formulation—the world’s central banks will start raising interest rates again. A return to global growth or simple demographic pressures or the aging of the world’s population will lead to higher rates of inflation.
And we all know the big important questions too: When? And What? Knowing what we know—about the likelihood of a bubble and the eventual breaking of that bubble—When do we take action to avoid getting caught up in the bursting of that bubble? And when we take action What do we do? Read more