Treasuries: Is end near?
It turns out the anemic recovery of the last few years was not quite ready to fly on its own and even if it was, political dysfunction may have thrown a monkey wrench into those plans by threatening the world with a self-made economic crisis. While a series of political missteps may have delayed the onset of taper, its inevitability makes Treasuries the most interesting market going forward and adds to the possibility of two-way volatility.
“It will be an interesting market going forward in the same way it was in 2013, but I don’t think it is necessarily because the bull market will end,” says Andrew Wilkinson, Miller Tabak’s chief economic strategist. “The market still has to come to terms with the Fed’s forward guidance. The market still has to come to terms with the lack of inflation and the breakdown in correlation between commodity prices and the value of the dollar.”
Treasuries overreacted to the initial taper scare in May and since have frustrated those waiting for the 30-year-plus bull trend to end. “I don’t think that the Treasury bull market is over. You have to recognize that we really are living in a new normal and we have a fiscal headwind restraining the economic recovery and that there is a lack of inflationary pressure that is going to maintain a steady cap on interest rates,” Wilkinson says. “It is very noticeable that the 10-year yield got down to 2.46% since the September non-taper meeting. I don’t think that necessarily is because the economy weakened substantially. [It] is because the Fed has been successful reaching an increasing number of investors with its message that even beyond finalizing its asset purchases the Fed Funds rate will not increase.”
Wilkinson, who sets the range in 10-year yields between 2.75% and 3.25% in 2014, adds, “To assume that yields will rise simply because the Fed stops its purchases is extremely Pavlovian. We just lived through a period when fixed income investors have been proven badly wrong on such an assumption. Real yields are a function of economic growth and activity as well as the pace of gains in employment. We shouldn’t blindly assume that yields necessarily go higher.”
Martin McGuire, managing director at TJM Institutional Services, is more bearish .
“If we see 10-year yields move to 2.85% from [the end of October yield of] 2.62%, it suggests that a multi-month low will be in place,” McGuire says. “While we might not see a new low yield at all, we should not expect to see one until after the end of the first quarter of 2014 ” (see “Is this the end?” below).
McGuire says the hard sell off in fixed income and equities this spring could have been an upfront insurance policy paid for future volatility. He says it could have provided for lower levels of volatility as the Fed moved toward tapering, but unfortunately the Fed’s failure to pull the trigger on tapering may be a lost opportunity. “By backing away from tapering in September, the Fed is back to square one. The market is once again wondering at every economic release what will be the implications for tapering,” McGuire says, adding, “I don’t think the Fed intentionally misled. They got together at the meeting and they believed then and there that the risk to their credibility from misleading the market was not as great as the risk of moving too early and taking the accommodation away.”
He expects 10-year yields to rise well above 3%, likely to 3.5% in 2014, and 30-year yields to move above 4% and approach 4.5%.
One of the reasons Wilkinson has been less bearish than many analysts on Treasuries is that he expects the Fed to hold onto its portfolio through expiration. “It is pretty apparent that the Fed’s balance sheet is going to be left to wind down of its own accord over an extended time horizon,” Wilkinson says. “So the descriptions of the bond market that many are predicting simply [are] not going to happen. The Fed will not sell bonds and force yields up. That idea is so counterintuitive that it makes no sense whatsoever.”
More interesting could be movement in the yield curve. “The 5-year/30-year yield curve is going to flatten like a pancake as the Fed moves through the tapering,” McGuire says. “If you believe the Fed has [the] intention to hold onto its portfolio, the policy rate will be required to do more of the heavy lifting. For any measure of economic growth (potentially inflationary), the Fed will need to raise policy rates more because it will not sell out the portfolio.”