SERIOUS MONEY:Market turbulence and economic weakness has increased the appeal of Treasury bonds, writes Charlie Fell
THE SECULAR bear market in US Treasury bonds that began in the summer of 1982 continues to march on with the yield on the 10-year declining from almost 15 per cent 26 years ago to less than 3 per cent today. While stock prices have dropped by 45 per cent in the year to date, Treasuries have generated returns of more than 9 per cent as investors have sought out the safety of default-free bonds. The massive divergence in the performance of the two asset classes has erased years of superior stock market returns such that Treasuries have now outpaced equities over the past two decades. Investors need to know whether the great bond bull market will continue and what the Treasury outlook means for stocks.
Treasury yields have dropped by more than two percentage points since the summer of 2007 as financial market turbulence and gathering economic weakness increased the relative appeal of government bonds. The downward momentum in yields has gathered pace in recent weeks as economic data revealed that activity is contracting sharply while the National Bureau of Economic Research (NBER) belatedly announced that the business expansion peaked 12 months ago. The length of the current downturn has already exceeded the recessions of 1990/91 and 2001 and looks set to match the harsh contractions of 1981/82 and 1973/75 in both duration and magnitude.
The prolonged recession arising from private sector deleveraging combined with a pronounced fall in asset prices means that deflation has become a very real threat. Indeed, break-even inflation rates implicit in the yields on Treasury inflation-protected securities (TIPS) have been moving in and out of negative territory across the entire curve since the spring. Although some of the movement in yields can be traced to the relative illiquidity of the TIPS market and the flight-to-quality evident in Treasury bonds, it would be unwise to think there has not been a sharp rise in deflation risks.
The economic expansion that began near the end of 2001 was notable for the surge in leverage. Each dollar increase in GDP was accompanied by a $5 increase in outstanding debt and in less than five years the total debt to GDP ratio jumped by more than 50 percentage points to almost 360 per cent. The deleveraging of this excess was always going to be deflationary but unfortunately, the Federal Reserve reacted slowly and mistakenly restrained the growth in high-powered money. Indeed, despite the Fed's conventional and unconventional stimulus measures over the past year, money growth turned restrictive during the summer as the initiatives were neutralised through the sale of Treasury securities.
Restrictive money growth can be traced to the central bank's concerns that surging food and oil prices would lead to inflation. The fears were misplaced as inflation was never likely in the presence of deleveraging and falling asset prices. It was a relative price shock that would eventually push prices lower across other consumer goods, particularly discretionary items. Consumers switched away from discretionary goods to food and oil costs.
The Fed has since reversed course and with the introduction of interest payments on bank reserves can now focus on the quantity of money rather than its price. The growth in high-powered money has surged higher in recent weeks but the Fed's actions will not necessarily be translated into broad money growth and an economic recovery thereof simply because the financial crisis has contributed to a decline in the traditional deposit multiplier. Counterparty risk and tighter lending standards have seen banks keep much of their newfound liquidity as reserves which is preventing multiple deposit creation. The banking system's reserves in excess of legal requirements have jumped from just $2 billion during the summer to an unprecedented $270 billion in recent weeks. Furthermore, the new money that has reached the real economy has had less effect than is typical due to a dramatic decline in velocity.
The Fed continues to flood the system with liquidity in an effort to reduce the stress in financial markets and just last week announced its intention to purchase $600 billion in agency debt. The announcement had immediate effect as mortgage rates fell sharply and forced mortgage investors to hedge prepayment risk. Lower long-term interest rates reduce duration of mortgage investments. To increase duration and provide a hedge against further decreases in yields, investors reduce short positions and purchase long-term Treasury bonds. This activity saw Treasury yields drop below three per cent.
The deflation risks combined with the Fed's aggressive measures to narrow spreads and keep long-term interest rates low is clearly positive for Treasury bonds but with the private sector deleveraging, a large fiscal stimulus package is certain in 2009 to inject some life into the economy. The increase in supply could reach $1.5 trillion which will clearly place upward pressure on yields. New issuance is already large though the bid-cover ratio at recent auctions remains stable and suggests that investor interest shows little sign of waning. This is likely to be the case so long as risk aversion remains high and the economy continues to deteriorate.
The bullish momentum in Treasury bond prices has gathered pace in recent weeks and though the low in yields may well be at hand a major sell-off seems unlikely in the immediate future. This is not good news for equity investors as current yields and shape of the yield curve are not conducive to a sustained upward lift in stock prices. The major averages appear to be range-bound for now such that allocations should not be increased without put option protection in place. Extreme caution is no longer warranted at current valuations but the rationale for excessive optimism remains absent.
