Are treasuries ready to turn

November 22, 2016 01:00 PM
Crowd-sourced earnings estimates from Estimize consistently outperform Wall Street.

The last 35 years has seen the 10-year U.S. Treasury note go from an all-time high yield of 15.84% to the current level of 1.70%. A lot has happened in that time to allow for falling yields, primarily a marked decrease in inflation. The Consumer Price Index (CPI) has fallen to a year-over-year increase of 1.1% (as of  August 2016) from 13.5%. Interest rates have moved in similar fashion. Is this a sign that the decades-long rally in U.S. Treasuries is officially coming to an end? 

As we turn the final corner on 2016, the U.S. economy seems to be closing the year stronger than it began. Not all economic indicators are pointing in the right direction, but with manufacturing, housing and consumer sentiment all showing positive improvements, it has made equities (just barely) the preferred asset class for investors as opposed to Treasuries, which have rebounded from their record low yield of 1.375% reached on July 5, 2016. And the Federal Reserve is expected to raise rates at its December meeting, one year after tightening began in December 2015. 

The Estimize community, made up of professionals from the sell-side and buy-side as well as non-professionals such as students and academics, polled users on expectations for the November and December Fed Funds Target Rate. For November, 64% of respondents expect no change, 29% are calling for a 25 basis point change and 7% a 50 basis point increase. For December, the expectation of an increase is more unanimous, with only 25% of users expecting no change and 75% calling for a 25 basis point increase. 

Amongst economists it’s pretty much a foregone conclusion that an increase will occur in December. Even BlackRock, the world’s largest money manager, warned investors back in October that they should reconsider their Treasury investments as Fed tightening becomes a reality. “It’s time to rethink the role of U.S. Treasuries in portfolios,” wrote global chief investment strategist, Richard Turnill. “We are cautious on long-term U.S. Treasuries.” He goes on to say that “depressed yields mean there is currently little safety cushion for holders of U.S. government bonds.” 

But, are equities really the better alternative? The general sentiment is that investors should tread lightly on equities as well, but at this point in the cycle they are just barely edging out Treasuries as the preferred asset class (“Last resort” below). 

More importantly, as the Fed moves toward normalizing rates, which sectors will benefit? Well one sector that is for sure looking forward to a rate increase is the financials. This sector is one of the most receptive to normalizing due to its capacity to lend and insure assets. Banks are able to capitalize from the perfect storm that is created when a rising rate environment is brought about by strong underlying economic growth. This results in expanding interest margins from the rate hike, and increasing economic activity usually translates to increased loan demand. With banks suffering from lower volumes of fixed income trading, and a lack of investment banking business due to a decrease in merger and acquisition activity and initial public offerings, a rate increase would certainly be a welcomed way to begin the New Year.

There is no doubt that this is a turning point for the United States as it’s been a while since we’ve been in a sustained rising interest rate environment, therefore making it difficult to predict exactly what will happen. The pace of rate hikes should be minimal and modest, protecting the markets against any prolonged volatility. As always, the key is to diversify, and despite rising Treasury yields that could minimize any potential yield income, government bonds still have an important role to play in investors’ portfolios, especially in flight to safety scenarios.

About the Author

Christine Short is a senior vice president at Estimize. An expert in corporate earnings, she produces content highlighting Estimize data. Prior to Estimize, Christine held positions at Thomson Reuters and S&P Capital IQ. @Estimize