Archive for the ‘US Treasuries’ Category
The title says it all: my next blog post will likely be up in August 2009, thanks to a four month sabbatical. Hopefully by the time I return from Southeast Asia / New Zealand / Fiji, the various Fed & Treasury efforts will be having a lasting – positive – effect on the economy. Regardless of if things will look better or worse, I am going to be back with charts and commentary on Wall Street and DC in the summer. In the meantime, feel free to continue to leave comments on my previous posts (they’ve been a huge source of value-add so far, thanks to all who contributed!); I look forward to picking up where we left off later this year.
I’ve written a some commentary on why I believe that the Treasury bubble is going to burst sooner or later. There are, however, a number of reasons for why what we’re seeing in the Treasury market may not be a bubble after all. The arguments below are taken from sources such as Capital Daily, Brad Setser, Merrill Lynch, Goldman Sachs and comments on my previous posts.
Argument #1: Low yields are justified as we are entering a period of sustained economic downturn, prolonged ZIRP and low inflation if not deflation.
If things continue to get worse, Treasuries may well continue to be the preferred safe haven asset for domestic and foreign investors alike. The general view coming out of Davos seems to be that we are in a severe global recession that will last through (or even beyond) the end of 2009. Market expectations, though, are still overly optimistic: Fed Funds futures are pricing in a rate increase by the end of the year. As market expectations slowly converge with economic reality, risk appetite will stay low and Treasury prices will remain steady. I personally believe this is the strongest argument against the ‘bubble’ hypothesis.
Argument #2: There is no reason to be concerned about the increase in issuance because the economic and financial conditions which prompt this increase simultaneously prompt a flight to safety.
Yes, issuance is increasing drastically – but it is increasing only because of the dire state of the economy, which goes hand in hand with a generally pessimistic outlook, high volatility with poor equities returns, low risk appetite, and investors’ flight to safety. This is an argument that I don’t buy, because you can easily reverse it: increasing issuance of Treasury bonds is a byproduct of the government’s attempt to restore investor confidence. Once the government succeeds, the flight to safety will abate and Treasury prices are going to come down.
Argument #3: Increased issuance and potentially stagnating foreign demand will be offset by increasing domestic savings rates, particularly by baby boomers.
Changing demographics may be a driving factor behind keeping Treasury supply and demand balanced despite increasing issuance and the potential drop off of foreign demand. The domestic savings rate is increasing, and the urgent need of baby boomers to save in order to fund their retirement will provide an increasing source of demand for Treasuries.
I’m on the edge about this argument. It is true that we are seeing an increase in the savings rate today after its short dip into negative territory in 2005. It is also true that the roughly 78m baby boomers are facing a savings crunch which was drastically exacerbated by the developments of the last eighteen months. At the same time, though, according to Corridor Inc. 20% of baby boomers have stopped contributing to retirement plans due to economic hardship. This leaves us with roughly 62.4m baby boomers who are actively saving. Some quick back-of-the-envelope math with simplified assumptions: the 2009 budget deficit is expected to reach $1.2 trillion, representing a ~10% increase to current national debt outstanding ($10.6 trillion). If we assume that Chinese demand falls off a cliff and China does not increase its ~$750 billion of Treasury holdings by 10% in fiscal 2009 (big assumption, I know), a demand gap of roughly $70 to $80 billion would need to be filled – translating into $1,100 of additional savings per baby boomer. That seems plausible in my opinion. At the same time there are so many moving parts in this equation – foreign demand, dollar strength or weakness, domestic risk appetite, savings rates – that I can only say: I don’t know what’s going to happen, but the sheer magnitude of the increase in supply makes me feel uncomfortable.
Argument #4: The government is firmly committed to quantitative easing and will keep yields down.
Ben Bernanke has made clear that the Fed is prepared to buy Treasuries, and the US government has strong incentives to keep rates as low as possible. Increasing yields in longer-dated Treasuries mean the housing market will continue to spiral downward as rates on fixed rate mortgages increase and other collateralized loans become more expensive. The negative wealth effect created by increasing borrowing costs will translate into even lower consumer confidence and consumer spending, and the effect will be doubly negative because borrowing is particularly important in times of high unemployment as credit is needed to bridge the income gap. I do believe that the government is fully committed to doing everything they can to keep yields low – but I also believe that what the government actually can do is limited; at some point, the government will run out of resources to keep yields down. To put numbers to it: a record $1.2 trillion of new issuance is expected in 2009; the Fed currently owns $475 billion of Treasuries, and the Fed’s total balance sheet stands at $2 trillion – but only because it has grown by more than 100% over the last twelve months. In my mind, if foreign and private domestic buyers decide to exit the Treasuries market there will be a whole that’s too big for the Federal Reserve to plug. At that point, quantitative easing will fail and the Treasury bubble will burst.
My verdict remains as before: I like short-dated Treasuries in a portfolio as disaster insurance, but would stay away from the long end of the curve because I am worried that yields will return to higher levels sooner or later. What do you think? In your opinion, what is the strongest argument in favor of Treasuries and against the ‘bubble’ hypothesis?
As the title says, this one is just for fun: a chart of the price of CDS on 10 year US Treasuries from April 2008 through January 27. The CDS priced at 68 bps today, after having hit a record high of 75 bps in the first week of December. According to FT Alphaville, the same contract trades around 2 (!) bps points in normal times. I should mention that the concept of CDS on US sovereign debt is somewhat flawed in my opinion (Who buys these things? Do people really think their counterparty will be around to honor the CDS if the US defaults? Isn’t the market too thinly traded for prices to be meaningful?), but their development is still interesting to watch. The chart below includes annotations on a few major Wall Street and Main Street events.
If you’re interested in commentary, I recommend the recent pieces by Greg Ip, Dean Baker and Felix Salmon for further reading. And if you have any thoughts on how sensible or flawed the notion of CDS on US Treasuries is, post a comment and let us know!
The government just successfully brought $40 billion of 2 Year Notes to the market, in the largest such auction in history – with the highest bid/cover ratio (2.69) since fall 2007 and a yield of 92.5 bps or 1.4 bps lower than anticipated by traders surveyed by Bloomberg, but markedly above the 88-89 bps range the when-issued notes where trading in. In reaction to the strong bid/cover ratio, Treasury prices are rising again.
So people are still buying Treasuries. That’s good news for the US, but I’m still worried about current price and yield levels especially given the increasing supply of bonds. To provide visual context to some previous posts about the Treasury bubble question, I am posting historical yield charts below. Take note of the previous record low yields (during the period of 1977 through the end of 2007) and the recent historical average yields since January 1990, which exclude the years of extraordinarily high interest rates in the early 80s.
90 day T-Bills: currently in the 10-20 bps range after having dipped into negative territory in December
2 Year Treasury Notes: trading below 1% while the recent historical average is 4.7% (since Jan 1990)
10 Year Notes: more than 300 bps below recent average levels (1990-2009)
30 Year Treasury Bonds: prior to 2008, the long bond had not dipped below 4% in decades
While I have come across a number of solid arguments for why Treasuries may actually be priced close to their fair value today, what comes to mind when I look at the above charts is “mean reversion.” What part of the puzzle am I missing, or what piece of data am I not paying enough attention to?
The Fed has pledged to step in and buy Treasuries if necessary in order to keep long-term yields down to make credit affordable, resuscitate the housing market and support consumer spending. But as issuance is increasing and foreign demand for Treasuries decreasing, will the Fed be in the position to purchase Treasuries in a sufficient volume to keep rates down?
- The 2009 deficit is expected to top $1.2 trillion – almost three times larger than the previous record at $440b in fiscal 2008.
- China, which accounts for ~25% of foreign (and >5% of overall) Treasury ownership, shows decreasing interest in US government debt: its foreign reserves were reported as shrinking in December ’08 and are expected to increase by only $177b this year compared to $415b last year.
Is the Fed going to be able to keep yields at their compressed levels for an extended period of time? I’m not convinced.
There has been much hype recently about the alleged bubble in US Treasuries. After returning more than 20% in 2008, Treasuries are now commonly viewed as a risky investment. Merrill Lynch and Goldman Sachs are among the few who believe that Treasuries are not overly expensive but fairly valued. More or less the rest of the world believes that the Treasury bubble is about to burst. And there is plenty of ammunition for the Treasury bubble view:
- Treasury yields are at historical lows
- issuance is increasing drastically as various domestic bailout packages have to get financed
- money supply in the US is increasing at an unprecedented speed, suggesting the dollar may weaken due to simple over-supply
- a weakening dollar, in combination with extraordinarily low yields, will decrease foreign demand for Treasuries
- Chinese demand for Treasuries will drop as China is struggling to finance its own domestic bailouts
- domestic risk appetite may increase at any time, leading to an investor exodus from the Treasury market.
I am sure that, over time, demand for Treasuries will weaken and yields will mean revert resulting in a sharp correction in prices. Hence my general advice to anyone holding Treasuries in their portfolio (i.e. hopefully everyone) would be to keep the exposure but shift the duration towards the very short end of the curve. I believe that Treasuries have run up in a huge way, and I do believe that they will come crashing down at some point – but I don’t know if it’s going to be tomorrow, in a month or in a year. In addition to not knowing when Treasury prices will correct, I like having Treasuries as a disaster insurance. I just don’t like the idea of potentially losing 20%+ on a long bond portfolio as yields are decompressing.
And here’s why I’m still a believer in Treasuries, even though I think the bubble is going to pop sooner or later:
There is a good chance that we haven’t felt the full effect of the credit crisis yet; if things get worse, there will be increased demand for Treasuries going forward. And while it is true that a weak dollar would decrease foreign demand, central banks around the globe are likely to be cutting rates over the next months as a response to the global slowdown (i.e. the dollar may remain comparatively strong). In addition – and this argument is lifted from Kessler, who recently made a smart case for Treasuries – demand for Treasuries may well increase once Obama puts together a concrete plan of action because political fighting will break out which will undermine confidence in a quick recovery and provoke a renewed flight to safety as the general outlook deteriorates. In addition, the US government has a number of incentives to keep rates as low as possible via the Fed funds target rate and quantitative easing:
- if yields in longer-dated Treasuries increase the housing market will continue to spiral downward as rates on fixed rate mortgages will increase (and so will rates on all other collateralized loans); this creates a negative wealth effect and translates into lower consumer confidence & consumer spending
- higher yields would have a doubly negative effect because borrowing is particularly important in times of high unemployment: credit needs to bridge the gap.
What do you think? Do you still hold Treasuries in your portfolio? And how quickly or slowly do you believe the US economy is going to recover?