The Case for an Allocation to U.S. TreasuriesBy Bob Andres | Jun 16, 2017
Mark Twain back in 1887 made it clear in a now famous quote that “reports of my demise are greatly exaggerated”. Twain went on to live another thirteen years. Like Twain the thirty-year bull market in bonds has continued to outlive those economists, street analysis and the financial press who have argued that interest rates were about to rise precipitously, causing severe economic hardship for those naïve and unsophisticated investors that continued to purchase and hold bonds. Professor Jeremy Sigel of the Warton School at Penn, in an article entitled “The Great American Bond Bubble” published in the Wall Street Journal on August 18th, 2010 set the stage for the hundreds and maybe thousands of published articles that followed, predicting higher interest rates and financial disaster for bond investors. Today, almost seven years, later the 10-year treasury yield is at 2.16% 64 basis points below the 2.80% yield back in 2010 when the good Professor tripped the bubble alarm. In the ensuing seven-year period the experts were wrong every single year in predicting significantly higher interest rates – In fact, 2013 was the only year where the 10-year treasury closed slightly higher than the 2.80% recorded the week the “Bond Bubble” article hit the streets. The lesson to be learned – Beware of the consensus – be skeptical and include counterintuitive thought in your investment analysis.
Let’s now make reference to the current interest rate environment and those factors that will determine interest rates out over the next few years. The trading range for the 10-year treasury in 2017 is a high of 2.62% in March and the low of 2.18%, which is the current yield level. The low in 2016 was 1.37%, which occurred in July. The trading range for 30-year treasury in 2017 is a high of 3.20% in March and a low of 2.84%, which occurred this past April. The low in 2016 was 2.11%, which occurred in July. Before getting into my analysis let me state with clarity that I don’t believe the bull market in bonds is complete or has run its course.
The Inflation Factor: Inflation is the worst enemy of bonds. The simple reason for this is that in a rising inflationary environment the return offered by a fixed rate bond is subject to losing part or all of the return to the rate of inflation. I believe we have had four inflation scares since the advent of the “Great Recession” in 2008. None have materialized. This has occurred despite the massive expansive policies of central banks. The Fed has made it clear that their primary inflation gauge is PCE or Personal Consumption Expenditures. This data point eliminates the volatile food and energy components in an attempt to better read broad inflationary trends. PCE currently sits at 1.54% significantly below the Fed’s long-term target of 2.0%. I will repeat my belief that sub 2.0% economic growth is not an incubator for inflationary growth and that is supported by the fact that we are in the latter stages of the business cycle. In addition, global inflation will not be a threat to the U.S. Inflation will not be an impediment to bond investing in 2017.
US Unemployment Rate – Are We at An Inflection Point? It may be counterintuitive to think negatively about the lowest unemployment in sixteen years. Our colleagues at Kessler Investment Advisors suggest “an unemployment rate of 4.29% is a signal to run-away from stocks and run to treasuries”. They point out that “historically, unemployment rate lows have occurred at, or very near-to, market inflection points preceding recessions. (See green and red hash marks in chart below). The unemployment rate just released on 6/2 /2017 at 4.29% is below the average unemployment lows prior to recessions over the last 67 years (4.4%). It is now below the low before the “Great Depression” 10 years ago, at 4.4% in March of 2007”. An unemployment rate this low in a weakening economy is indicative of how late we are in the business cycle.
The Risk Trade Appears Vulnerable:
- We are in the late stages of the business cycle with anemic economic growth (car sales, housing, consumer employment and sales are weakening) and the economy has nominal potential based on the discord and bedlam in Washington. The last recession ended in 2009 and we currently have a Fed bent on tightening for non-economic reasons. In addition, we have growing geo-political risks that are adding to uncertainty and risk levels.
- Corporates and high yield spreads are very tight to treasuries. Any further economic weakness or a decline in equity prices will widen spreads and favor treasuries
- A flight to quality, should it occur for the reasons stated just above would extend the bull market in treasuries and municipals in my opinion to record low yields. While I don’t expect a repeat of the magnitude that occurred in the January 2008 to June 2010 period it is worth referencing – The investment Company Institute reported outflows from equities funds totaled $232 billion and inflows to bond funds of $559 billion for the period in question.
- The other reason the risk trade appears vulnerable is that the equity valuations are overvalued by any traditional metric and markets don’t go one way forever – a reversion to the mean is always part of the end story. I believe we are edging closer to an inflection point with regard to the “risk-on/risk-off trade”.
- The risk-off trade has nominal downside for the investor
Treasury Yields are Attractive in Comparison to those Overseas: Money has a tendency to go where it is treated the best. The chart below highlights the yield differentials among industrialized nations. The yield on the 10-year Treasury at 2.20% broadly exceeds almost all the nations listed. Take a close look at the spread among the United States, Germany, France and Japan.
Selected 10 Year Government Bond Yields (close of business 6/9/2017)
In addition, United States Treasuries remain a safe haven in an extremely volatile geo-political environment. The street is seeing some buying interest coming out of the Far East including China. Reinforcing a point with some anecdotal information regarding foreign selling of treasuries in 2016. Between June and November 2016 foreigners sold $335 billion in treasuries of which $191.5 billion was attributed to China. The financial press again went on another fear mongering tear basically calling for substantially higher yields and the end of life, as we knew it. The 10-year treasury began the month of June at a yield of 1.85% and post selling closed on November 1, 2016 at a yield of 1.83% a decline of 2 basis points. Again, beware of the consensus, be skeptical, and include counterintuitive thought in your investment analysis.
Bob Andres – June 11, 2017