PRINTMarket Update -- In the Markets
December 10, 2009
The Treasury market has put in an impressive performance these last few months, rallying through record supply, improving economic data, rising stock and commodity prices, a weakening dollar, and widening Treasury Inflation-Protected Securities (TIPS) inflation breakevens. Much of the recent strength has been attributed to repeated assurances by various members of the Federal Reserve that the overnight lending rate will be held at the zero-bound for an "extended period," and that economic conditions will continue to keep inflation risks in check. Or, it could just be that there’s a lot of money out there looking for a home.
Domestic banks, awash in cash, have been buying securities rather than writing new loans. Cheap funding, a steep yield curve, and repeated assurances by the Fed that overnight lending rates will remain low well into next year provide all the motivation these banks need to keep buying bonds. Foreign central banks, likewise, are buying large amounts of Treasuries as they invest their growing foreign currency reserves in dollar-denominated debt. Individual investors, tired of earning zero on their money market fund holdings, have been allocating more of their investment dollars to higher-yielding fixed income funds, with many large mutual funds receiving record inflows this year. And finally, the Fed itself has been buying. Through its quantitative easing initiatives, the central bank purchased $300 billion in Treasuries this year, making the Fed the single largest buyer of U.S. Treasuries in 2009. Furthermore, by buying well over $1 trillion worth of agency debt and agency mortgage-backed securities (MBS), the Fed has taken massive amounts of high-grade fixed income supply out of the market this year. In fact, when adjusted for Fed purchases, net supply of fixed income (new issuance minus maturities and Fed purchases) has actually been negative this year--something rarely seen in financial markets.
Considering the many factors that have gotten us here and some of the dynamics and risks we anticipate going forward, we once again reiterate our view that investors will be best served by reducing the interest rate sensitivity of their fixed income portfolios.
Our rationale is based on valuations, economic fundamentals, monetary policy expectations, and our current assessment of the balance between risk and reward.
First, we cite the absolute level of Treasury yields, which is low by any historical measure. As of this writing, five-year notes, at just over 2%, are down 75 basis points from their high in June and barely above the lows seen during the deflation scare in 2003. With recent economic data pointing to continued economic growth and inflation indicators showing stability at current levels, real yields don’t look very compelling by historical standards either. In fact, with core CPI now back up to a year-over-year rate of 1.7%, the inflation-adjusted yield of five-year notes is now right around the lows of 2002-2003, and more than two standard deviations rich to its long-term average of roughly 2.5%.
Second, we cite the broader improvement in economic conditions that have seen both the manufacturing and service sectors return to growth, the housing market begin to recover, and the labor markets stabilize. Recovery in the financial markets, meanwhile, has also led to rising stock and commodity prices and improving liquidity conditions, reducing the value of Treasuries as a safe-haven instrument.
Third, even if Treasuries benefit from an increase in demand from investors, they have very little scarcity value given the ongoing growth in issuance. This increased issuance is needed to fund the growing budget deficit (estimated to be well north of $1 trillion in FY 2010), and the Treasury Department has also stated repeatedly that it intends to extend the average maturity of its debt, placing an additional duration burden upon the markets.
Fourth, the single largest buyer of U.S. Treasuries in 2009, the Federal Reserve, has completed its purchase program and will soon also complete its planned purchases of U.S. agency debt and agency MBS. One should be careful not to underestimate the impact that these purchase programs had on the bond markets this year ($1.75 trillion isn't exactly chump change). With this buyer out of the market, the burden will rest squarely on the shoulders of traditional investors. We wonder how willing they will be to pick up the slack at the same time that Treasury issuance is expanding and economic growth is returning. Moreover, there’s also a risk that, if the markets begin to overheat, the Fed will actually begin to sell off some of these assets. Just as the absence of a $1.75 trillion buyer will surely be felt, the market impact of even a modest asset sale program would be even more acute.
Fifth, the unprecedented expansion of the monetary base by the Federal Reserve, through its various policy initiatives, worries us. Increasing the supply of dollars almost always results in inflation. There are those who argue that, because of a lack of credit creation, the massive excess bank reserves are not entering the system and therefore do not pose a threat. That may be the case today, but a re-emergence of loan demand amid low borrowing costs and a recovering economy could eventually find banks more eager to lend at these attractive interest margins–at which point inflation pressures will indeed begin to grow or the Fed will need to act aggressively to drain reserves from the system. Either outcome would be negative for Treasuries.
Sixth, indications that many members of the Fed, including its chairman, appear to be growing somewhat complacent about the aforementioned inflation risks make many investors, including ourselves, question the Fed's credibility on this front. An over-reliance on output-gap analysis by many Federal Open Market Committee (FOMC) members, in our view, risks missing the bigger picture. We would remind policymakers that the output gap is difficult to measure and remains unproven as a predictor of inflation. Indeed, some noted economists argue that it is not the size of the output gap but the direction and magnitude of its change that influences prices. If the Fed wishes to reassure us that its stimulative monetary policy initiatives and massive expansion of the monetary base are not inflationary, its arguments will need to be a little more convincing.
And finally, the prospect of diminished central bank independence should also worry investors. Aggressive Congressional scrutiny and pending legislative measures aimed at stripping the Fed of many of its powers while subjecting its policy prescriptions to Congressional audit has very negative implications for the bond markets. A Federal Reserve that must answer to elected officials is much more likely to err on the side of pro-growth policies at the expense of long-term price stability. The implication is clear–the loss of Fed independence will raise the risk of long-term inflation. And this is true even if its voting members remain true to their principles, simply because inflation expectations will rise as consumers ponder the inherent conflicts faced by a Federal Reserve that answers to Congress. Rising inflation expectations can at times manifest actual inflation, and a general increase in longer-term inflation expectations should, at the margin, cause Treasury yields to rise and the yield curve to steepen. Moreover, the damage such a move would inflict on the Fed's credibility would make U.S. Treasury debt much less appealing to overseas investors and may exert further pressure on the dollar and its value as a foreign currency reserve.
In light of these considerations, we would characterize the relationship between risk and reward in the Treasury market as skewed decidedly in favor of higher yields, and we are positioned accordingly. While we respect the view that Treasuries could rally further into year-end, we feel that over the course of the next few months we are likely to see a significant move higher in yields, perhaps testing or even surpassing the highs seen in June of this year. We also feel that, despite somewhat lofty valuations, TIPS have the potential to continue to outperform nominal Treasuries in the medium term, and continue to maintain a modest allocation to that sector.
Market Update
RSS