The Treasury “bond rally of a lifetime” still seems intact. The “risk on” investment climate for U.S. equities persists, but as in 2014, we approach it with trepidation and with a defensive portfolio position. The U.S. economy is continuing to grow but at subpar rates (Chart 1) while growth in China is slowing, is very sluggish in the eurozone and negative in Japan.
The dollar is reigning supreme and 2015 may turn out to be the year of the greenback as almost every other currency declines against the buck, especially the Euro and Yen.
Treasury bonds. There are many reasons why we continue to favor long Treasury bonds. Here are 10:
1. Safe haven. Like the U.S. dollar, Treasurys are a safe haven in times of global turmoil and uncertainty, of which there are plenty today.
2. Deflation, extant in many countries (Chart 3) and looming in many others including the eurozone, makes current Treasury note and bond yields attractive.
3. Quantitative Ease, underway in Japan and likely soon in the eurozone, provides money to invest in U.S. Treasurys.
4. Treasury yields are attractive relative to those abroad. The 2.17% yield on the 10-year Treasury note vastly exceeds the 0.54% yield on 10-year German bunds, 0.33% for 10-year Japanese governments (Chart 4) and almost every other developed country 10-year sovereign (Chart 5). With the new round of QE in Japan and impending QE in the eurozone, the BOJ and ECB will be buying more government securities, sending yields even lower. The U.S. government obligation is probably at least as high quality as any of these others, and the rising dollar against the euro and yen enhances the appeal to foreigners of buying U.S. debt. What are we missing?
5. Foreigners are buying Treasurys. In the December sale of $13 billion in 30-year Treasurys, indirect bids, a measure of foreign demand, took 50%. The Fed is no longer adding to its Treasury portfolio but foreigners, as well as domestic investors, are more than replacing Fed purchases. With half of Treasurys owned abroad, it is truly a global market.
6. U.S. banks are buying Treasurys as they move away from lower-quality assets, in part to comply with new rules requiring the biggest banks to hold more liquid assets and 60% of these must be backed by the federal government. Also, in counting towards liquid assets, corporate obligations get a 50% haircut but those backed by the full faith and credit of the federal government get 100% credit.
7. Long Treasurys continue to be attractive to pension funds and life insurance that want to match their long-maturity liabilities with similar duration assets.
8. Junk and corporate bonds are losing favor vs. Treasurys. The spreads between junk vs. Treasurys are widening as Treasurys rally while junk bonds sell off under the weight of heavy issues and investor worries about defaults, especially on weak energy company issues. At the same time, the spreads between Treasury and investment-grade yields are widening. Note that energy bonds represent about 20% of most fixed-income benchmarks. Companies are issuing debt at the fastest rate on record, often to fund dividends and share buybacks. Meanwhile, the issuance of Treasurys is shrinking as the federal deficit falls (Chart 6). Unlike the ECB, which is likely to buy corporate debt, the Fed is highly unlikely to do so. This pushes money from U.S. corporates to those in Europe.
9. The odds of a near-term Fed rate hike are receding. Early last year, the futures markets assigned a high probability to an increase by year’s end. Now these markets indicate that the odds are receding, with a 24% probability of an initial Fed rate increase by June and 51% by July. And these numbers will no doubt be pushed out further as the deflationary effects of the oil price plunge sink in and investors—and the Fed—realize that foreign central bank stimuli amount to Fed tightening, relatively.
After its December policy meeting, the Fed said it would be “patient” before raising interest rates, adding that the overall outlook hadn’t changed much from earlier assurances that its policy rates would stay at essentially zero for a “considerable time.” Fifteen of the 17 policy committee members expect rates to rise this year and their median forecast was for 1.125% in 12 months through December, 2.5% in 2016 and 3.625% in 2017. As we’ve noted in past Insights, however, in recent years they’ve consistently forecast stronger economic growth and quicker rises in interest rates than have materialized.
Of course, the Fed is right in step with private forecasters. The Wall Street Journal’s poll of 49 forecasters (not including us) back in January 2014 found that 48 expected yields in the 10-year Treasury note to rise from 2.9% at that time to an average forecast of 3.5% by year's end. It moved in the opposite direction and ended 2014 at 2.17%, as noted earlier.
We continue to believe it will be years before the Age of Deleveraging ends and, with it, slow growth, and the Fed shifting to selling securities and raising rates. The recent nosedive in commodity prices and deflationary implications will probably stretch out the central bank’s time line.
But what if, contrary to our forecast, the Fed raises its benchmark rate before the Age of Deleveraging is completed? When it hinted at tapering its then-$85 billion in monthly asset purchases in May and June of 2013, Treasury note and bond yields leaped. Nevertheless, these moves were out of keeping with history. Interest rates rose in the post-World War II era up until 1981 as inflation rates climbed, but have fallen since then with receding inflation. After removing these trends, first up and then down, we examined the relationship between the Fed benchmark, the federal funds rate, and the yields on both 10-year Treasury notes and 30-year bonds.
On average, the spillover from federal funds was small, with a one percentage-point rise pushing up the 10-year note yield by 0.35 percentage points and the 30-year bond yield by just 0.23 points. So, we don’t expect a nosedive in Treasury note and bond prices even if the Fed tightens credit earlier than we forecast—unless the 2013 Taper Tantrum marked the beginning of a new relationship. Recall, however, the sage words of Sir John Templeton: "The most dangerous words in the English language are, this time it's different."
10. Postwar babies are aging and this favors Treasury's as older people reduce the riskiness of their portfolios and favor high-quality bonds, despite low yields.
11. Speculators are increasingly short the benchmark 10-year Treasury note in the futures market. If the rally in Treasury prices persists, sooner or later they will be forced to buy back their shorts, adding to demand.
More Treasury Rally Ahead
We expect a further rally in Treasury prices with the 30-year yield dropping from the current 2.75% to 2.0%, perhaps by the end of 2015. If so, the Long Bond would provide a total return of 18.8% and the 30-year zero coupon bond, 24.6%. If the 10-year note yield drops from the current 2.17% to 1.0%, as we forecast, the total return would be 12.4%. These may seem like big gains for yield declines of only about one percentage point, but that’s what happens when yields are low. In any event, we believe that “the bond rally of a lifetime” marches on.
In past Insights, we’ve explored the Grand Disconnect between slowly-growing major economies and soaring equity markets, propelled by central bank money and, in the U.S., by unsustainable corporate cost-cutting as well.
This gap will get closed sooner or later, either by Fed tightening and the recession that has followed in 11 of 12 similar incidences in the post-World War II era, or a substantial shock that will have the same effect. The resulting recession will no doubt become global, given the already weak state of many foreign economies and financial structures.
We also stated that it will be years before the Age of Deleveraging and slow economic growth are concluded, and the Fed then begins to raise interest rates and shrink or sterilize the $2.3 trillion in excess member bank reserves that have accumulated with QE. So a major shock may occur before the Fed shifts gears toward credit restraint. The obvious current possibility, of course, is the financial fallout from the ongoing weakness in commodity prices, especially crude oil, and the soaring greenback.
In “Past External Financial Shocks and Their Effects” (also in our January 2015 Insight report), we examine the effects of past shocks on the U.S. economy, going back to the 1973 Arab oil embargo.
The dollar was up over 7% last year against emerging economy currencies, and about $1 trillion in their corporate bonds were issued before the buck surged. So the cost of servicing those dollar debts is climbing, much as in the late 1990s when a similar problem with government dollar issues precipitated the Asian financial crisis that led to defaults in many Far Eastern economies as well as Russia, Brazil and Argentina.
Last year, companies in emerging markets issued almost $280 billion in dollar-denominated bonds to take advantage of low interest costs. Governments have joined this parade but not as extensively as in the late 1990s. Still, total company and sovereign debt issuers had $6 trillion in outstanding bonds at the end of 2014, up four times since the 2008 financial crisis.
As investors retreat from these emerging markets to dollars, local currencies will fall even further. The Indonesian rupiah, Chilean peso, Brazilian real and Turkish lira are near multi-year lows and the Mexican central bank recently spent $200 million to support its peso. The IMF and Bank for International Settlements worry that exchange rate problems could sire corporate defaults and asset price busts worldwide.
In any event, a major shock and resulting recession would shift the investment climate from the current “risk on” to “risk off,” emphasizing what we call the Quartet—Treasurys and the dollar would be attractive as safe havens while equities of all types, be they in developed, developing or frontier markets, would be dumped along with commodities. Interestingly, three of the four members of the Quartet are already on the stage and beginning to play. Treasurys are leaping in price. The dollar is soaring against almost every foreign currency. And commodity prices are plummeting. Only stocks are yet to enter the stage and tune down.