US Treasuries Still a Safe Haven and the Yields on TIPS Remain Negative

International investors still flock to the United States Treasury bond market to keep their funds in a “safe place”.  As a consequence of this, interest rate relationships continue to be distorted.  Since early August 2011, the yield on the 10-year US Treasury bond has fluctuated somewhere around the 2.00 percent level. 

These declines occurred during the fall events that surrounded the fiscal problems in Greece.  The yields have remained at these low levels through the Greek restructuring and into the recurring concerns over the budget fights in Spain and Italy. 

The dramatic drop in the Treasury yield can be seen in the accompanying chart.  The 10-year Treasury was trading at or above 3.00 percent up until early August 2011.  Then the drop occurred.  And, the yield has basically moved around 2.00 percent since then. 

The interesting thing to me in this shift is what has happened to the yield on US Treasury Inflation-indexed securities.  They went negative in early August and, after bouncing around for a couple of months, dropped into negative territory again in early November and have stayed there since.  This can be seen in the chart below.  Yesterday the 10-year Treasury inflation indexed bond closed to yield a negative 0.31 percent.

The Treasury inflation indexed bond, since it was created, has served as a proxy for the “real” rate of interest.  It has varied a great deal more than one would like an “expected” real rate of interest to vary, but it, nonetheless has provided a benchmark that can be useful in analyzing what is going on in financial markets. 

Theoretically, the “real” rate of interest should be equal to the long-run rate of growth of the economy.  Over the past fifty years, a “rough” workable estimate for the real rate of interest was 3.0 percent, which was close to the compound rate of growth of real GDP from 1960 to the 2000s.

One could then get a “rough” estimate of the inflationary expectations built into interest rates by subtracting this estimate of the real rate of interest from a nominal rate of interest, the yield on the 10-year US Treasury bond.  Then one could compare the yield on the Treasury inflation indexed bond with these other measures in an attempt to understand what was currently going on.

In the current situation, one hard to support any proxy estimate for the “real” rate of interest.  The old estimates derived from the real growth rate of GDP seem useless given the current environment. (http://seekingalpha.com/article/503181-economic-growth-will-continue-entering-the-next-stage)  And, the combined effects of the Federal Reserve’s quantitative easing and the “flight to quality” of the international investor have distorted market relationships.  That is, the past is not a good guide to the present interest rate relationships.

Rather than starting with an estimate of the “real” rate of interest, it seems that the place where one should begin is the nominal yield, the yield on the 10-year Treasury security.  Yesterday, the 10-year Treasury security closed with a yield of just about 2.00 percent.  The yield on the 10-year Treasury inflation indexed security closed at about a negative 0.30 percent. 

The difference between the two, about 230 basis points can be used as an estimate of the inflationary expectations of the market.  The year-over-year rate of increase in the price deflator for GDP was slightly about 210 basis points.  Thus, one could argue that the relationship between the yield on the 10-year Treasury security and the yield on the 10-year Treasury inflation indexed security…the proxy for inflationary expectations…was roughly in line with the actual inflation going on in the economy. 

One could then argue that the yield on the 10-year Treasury inflation indexed securities is negative because the flight to quality, along with the quantitative easing on the part of the Fed, has resulted in the yield of the 10-year Treasury reaching such a low level.  That is, the Fed’s actions along with the European financial crisis has distorted interest rate relationships to the point where we actually have some market interest rates that are negative.  The inflation-indexed security bears a negative yield because investors still must consider how actual inflation will impact the nominal returns they receive on their bonds.  Given the inflation that is expected by the market and given the current level of yields on “risk free” securities, the “real” yield in the market place can be no where else but in negative territory. 

Here, then, is a way to interpret the extent of the financial upheaval going on in the world.  If the yields on the Treasury’s inflation indexed bonds remain negative or extraordinarily low, then one can assume that the risk-avoidance going on in the world is still quite high.

Treasury Bond Yields Will Continue to Rise

Treasury bond yields are on the rise and will continue to do so over the next year. 

In my opinion, the Federal Reserve System has been given more credit than it is due concerning how low long-term Treasury securities had fallen in the past year or so.

The research I have seen during my professional career has shown that the Federal Reserve, from time-to-time, has attempted to influence the yield on long-term Treasury issues but has never been very successful, either in terms of the its ability to lower long-term yields by much or in terms of keeping them lower for an extended period of time.

This is not true, however, of short-term yields. 

I continue to believe this.

The yield on the 10-year Treasury security has been extremely low for several months now.  Around the end of July 2011, the yield on the 10-year was about 3.00 percent.  It dropped precipitously after that time, falling around 2.10 percent by August 18 and then falling below 2.00 percent the second week of September.

Since then, this yield has fluctuated between approximately 1.80 percent and 2.10 percent until last week (except for a three day bump up right at the end of October).

The most interesting move during this time period, however, has been the move into negative territory of the 10-year TIPS bond.  At the end of July 2011 the 10-year TIPS was trading around a 0.50 percent yield (which was already low historically).  On August 10 the yield had become negative, trading around a -0.155 percent yield.  That is, we had a negative real rate of interest. 

For a good portion of the time since then the yield on the 10-year TIPS has been negative.  Yesterday, this issue closed at -0.056 percent yield.

The reading on this behavior?  The movement into Treasury securities this summer was a “flight to quality” and was not a result of the actions of the Federal Reserve System. 

The Federal Reserve cannot force interest rates…long-term or short-term…below a zero interest rate.  The Fed has been very successful in keeping its target rate of interest, the Federal Funds rate near zero, but admits it cannot force this rate below zero. 

Why would investors invest in something that had a below-zero interest rate on it?  The basic reason is that these investors wanted to invest in Treasury securities…regardless of the yield.  This represented a “flight to quality” and the movement of funds affected the yields on all long-term Treasury securities.

One should note that with all the liquidity available to the financial markets, the spread between US Treasury issues and Aaa Corporate bonds rose during this time.  You do not find this type of behavior taking place except in times when there is a flight to quality.

One should also note that there was also a “flight” to German sovereign debt at this time as the yield on the 10-year German government issue fell, although not by as much as did the yield on the US Treasury issues.

The movement in Treasury yields last week was a movement back into riskier assets.  This is confirmed in a New York Times release this morning concerning the actions of hedge funds. (See “Hedge Funds Ditch Treasuries in Droves: Report”, http://www.nytimes.com/reuters/2012/03/19/business/19reuters-hedgefunds-treasuries.html?src=busln&nl=business&emc=dlbka32_20120320)

“A good deal of the recent flight from U.S. Treasuries has been driven by hedge fund selling…

Last week was the biggest weekly decline for U.S. Treasury prices since last summer. The big sell-off in government debt pushed yields to their highest levels in more than four months.

It was a sign investors see less need to put money in Treasuries for safekeeping now fears of a messy Greek debt default are fading and the U.S. jobs picture looks brighter.”

This, to me, makes much more sense than does the argument that this movement is the beginning of the bear market in bonds. (See “Bond Bear Market is Growling but Yet to Roar,” http://professional.wsj.com/article/SB10001424052702303812904577291770173587542.html?mod=ITP_moneyandinvesting_6&mg=reno-secaucus-wsj)

Also, as the yield on 10-year Treasury securities rose last week the yield on 10-year German bonds rose as well.

Long-term yields will begin to rise at some time in the future but I don’t believe that we have reached that stage of the cycle at this time.  The bond market still needs to re-position itself to risk-based assets and reduce its need for a “safe haven.”  This will continue, I believe, for the short-term. 

I think that the yield on the 10-year Treasury needs to return to above 3.00 percent and the yield on the 10-year TIPS bond needs to get back up into the 0.50 percent to 1.00 percent range.  This will restore some of the relative yield spreads to levels that are more consistent with current economic conditions. 

These yields will begin to rise along with economic growth as the economy picks up steam.  However, I don’t see that there will be much “steam” in the next three or four quarters. (http://seekingalpha.com/article/437481-economic-recovery-the-good-and-the-bad) 

Furthermore, the Federal Reserve will continue to err on the side of ease until the economic recovery does appear to accelerate.  Although Fed ease will not hold down long-term interest rates once they begin to climb on any experienced economic pickup, the Fed wants to avoid disruptive bank failures or other surprises that might occur on the path to recovery.

Of course, we could always have another situation in which a further “flight to quality” would cause long-term Treasury yields to drop.  Greece is not out-of-the-woods yet, and there is still Ireland, Portugal, Spain, and Italy to deal with.    

The Credit Markets: Two Apparent Contradictions

The yield on the 10-year US Treasury bond closed at 2.301 percent on Friday.  The dramatic rise in this yield at the end of last week has many analysts worried that the bull market in bonds is over. 

The yield on the 10-year Treasury was 2.384 percent at the close on last October 27 and at the end of July 2011, the yield was around 3.00 percent, where it had been for some time.

Note that a large portion of the time that the yield on the 10-year Treasury had been at these higher levels, the Federal Reserve had been operating under a policy of quantitative easing.

What set off the decline in yields in August and September was a series of things that lead to a rush into gold and a flight to quality in the financial markets. 

The price of gold had remained relatively stable in the May and June period, but began steadily increasing in July and August.  By August 2, the price of gold reached $1660 per ounce and then flew through $1700 on October 8, the day of the S&P downgrade of US debt.  By August 18, the price closed at $1828 and almost closed at $1900 on August 22.

Even more startling, the yield on the 10-year TIPS turned negative in early August.  On August 10, this yield was -0.155 percent!  In late July it had been trading to yield above 0.500 percent. 

The 10-year Treasury yield plummeted from about 3.00 percent on July 29 to 2.40 percent on August 4 and about 2.00 percent on August 10.

The stock market was also highly volatile during this July/August period. 

And, Treasury yields remained low through the whole Greek debt restructuring that took place throughout the fall into the new year of 2012.

My view: over the past month or so, financial markets have calmed somewhat, primarily due to the Greek situation, and this has been leading to a movement of funds out of US Treasury issues and into riskier “stuff”. 

Then we got the news last week from Mr. Bernanke that the Fed was not going to do much in the way of bond purchases in the near future and, in particular, there was no inclination on the part of the Open Market Committee to engage in a new phase of Quantitative Easing. 

These two factors, I believe, are leading to a reversal from the previous “flight to quality” in the financial markets. 

Since January the ratio of the yields on government bonds relative to Aaa-rated corporate securities has been rising, indicating funds were flowing more freely into other sectors of the financial markets.  Furthermore, the ratio of yields on Aaa-rated corporate securities to Baa-rated corporate securities was rising indicating a relative move to less highly rated credit. 

Therefore, I am less concerned about an end to the “bull market” in Treasury securities than I am about a market adjustment that has followed the “flight to quality” that took place last summer. The economy continues to expand (http://seekingalpha.com/article/437481-economic-recovery-the-good-and-the-bad) and monetary policy will continue to be supportive of a still fragile banking system. 

I am looking more for a relative rise in the yield on US Treasury securities as an indication that funds are flowing back into other areas of the financial markets rather than for a cyclical increase in yields due to a strengthening of the economy. 

There is a second issue I would like to clear up that was brought to my attention by someone commenting on the above mentioned blogpost. (http://seekingalpha.com/article/437481-economic-recovery-the-good-and-the-bad)

In this blogpost I discussed the continued deleveraging taking place in the American economy and the rise in bank lending, which I took as a positive sign that the economy would continue to grow.  One person who commented on this post stated that the idea that deleveraging was to continue but bank lending was increasing seemed to be contradictory. 

As such, the two pieces of information does sound contradictory.  In arguing that “both” of these conditions can exist within the economy I draw on a point I have made continually over the past several years.  My argument has been that over the past fifty years or so the United States government has conducted a policy of credit inflation.  This credit inflation has helped to bifurcate the society as those with more wealth and better access to advice and consulting have been able to protect themselves from the inflation or even take advantage of the inflation to improve their position in the economy.  The less-well off have not been able to even keep up with what is going on.  As a consequence, the income/wealth distribution in the United States has become even more skewed to those possessing wealth. 

As I have described in other places, the current economic policies of the United States government just exacerbate this movement.  That is, the economic policies of the United States government are making things even worse.  Deleveraging continues, but generally amongst those that are less well off, those who are heavily in debt, those who often find themselves underwater with respect to the ownership of their own home, and those who have little or no savings. 

Lending is picking up to others, businesses as well as households, that are not is such a situation.

Thus, you can have bank loans increasing in the economy while many in the economy still have to reduce their financial leverage to even keep going.  I believe we are in such a situation.