The U.S. Government debt market, also referred to as the U.S. Treasury market, is one of the most important financial markets in the world because Treasury prices determine the base price for so many different assets.
Last year was a shockingly strong year for U.S. debt, where the 30-year Treasury gained 30% in value and caught most of Wall Street off guard. As we enter the New Year, one of the key controversies involves the future of Treasury bond yields, which are influenced by three key factors:
1. The Fed’s monetary policy
2. Investor demand for U.S. debt
3. The amount of new debt issued by the U.S. Treasury Department
Let’s analyze each of these factors in order to predict the near-term direction for Treasury prices and yields. Bond prices move inversely to their yields, so as the yield on a bond rises, its price falls and loses money for the owner of that bond.
Fed policy is critically important to longer dated Treasury bonds, in particular the 10-year and 30-year U.S. bond, because a rise in the short-term rate (controlled by the Fed) will result in an outsized move up in long-term yields.
Since the Fed will likely keep short-term rates at or near zero through the end of the year, the risk of falling Treasury prices and rising Treasury yields on account of Fed action is quite low.
Next, let’s compare supply against demand because the battle between these two is the driving force behind the price of nearly every asset class that is freely traded. Starting with the demand-side, I expect the demand for Treasuries to remain very strong for three key reasons:
1. Financial Institutions: New regulations are requiring banks, insurance companies, and other large financial institutions to hold more liquid assets to prevent another financial crisis. The buying from these entities will likely continue as they de-risk portfolios.
2. Relative Attractiveness: Long-term government debt in other countries like Japan and Germany are paying a fraction of the yield offered from U.S. debt, and these countries have neither the depth nor the breadth of the Treasury market. Hence, on a relative basis, Treasuries pay higher yields and carry lower risk than all other large, developed countries.
3. Safe Haven: The U.S. Treasury market is by far the most liquid financial market in the world, and investors across the globe come here knowing that they can buy/sell freely when fear and panic enter riskier markets.
The table below reinforces point #2 above, by showing the current yields on 10-year government bonds across the globe.
The table above shows just how attractive U.S. debt remains when compared to other developed countries.
For example, would your prefer to earn 1.54% for 10 years from Italy, a country with an incredibly weak economy that almost defaulted three years ago, or would you rather earn 1.86% from the U.S. with no risk at all of default?
Simply put, Treasuries offer the most attractive yield on a risk adjusted basis of any major economy in the world, and this demand should remain strong for the foreseeable future.
A country issues debt when its government intends to spend more money than what they will bring in through tax revenues. For example, if a country determined that they need to spend $10 billion in 2015, but only $7 billion in revenue from taxes was projected to be collected, then the government would need to issue $3 billion in debt to cover the projected expenses ($10 billion – $7 billion = $3 billion).
The U.S. government has spent a jaw dropping amount of money over the last decade, which far exceeded any revenues received through taxes and other sources. The chart below shows just how much debt has been issued annually over the last 20 years.
Although debt issuance surged in 2008, this chart alone tells very little about the supply outlook for this year. Therefore, let’s look at the growth rate for new debt creation during that time to see just how fast our leaders were issuing new debt.
Source: U.S. Treasury
Despite a meteoric growth rate from 2008-2011, the U.S. Treasury has slowed the rate of new debt creation dramatically.
In fact, the federal budget deficit for the 2014 fiscal year was just 2.8 percent of GDP, the lowest level since 2008, and the Congressional Budget Office (CBO) has forecasted that the fiscal deficit will contract even further in 2015. Additionally, the U.S. Treasury confirmed back in December that new issuance of debt will also be at the lowest level since 2007, thanks to higher tax receipts from an improving economy.
The net effect of supply unable to meet demand in the Treasury market can be witnessed in the “bid-to-cover” ratio, which is the key measure of demand for Treasuries.
This ratio compares the amount of demand against the available supply of Treasuries at the most recent auction. For example, if the U.S. Treasury department offers $10 billion of securities for sale and buyers enter bids for a total of $20 billion, the bid-to-cover is 2 ($20 billion/$10 billion = 2).
The higher the bid-to-cover, the more demand exists for Treasuries. Currently, this ratio is at 3.0 for the 10-year Treasury, which is a historical high and supports the conclusion that demand for U.S. debt remains well ahead of supply.
As with most predictions in financial markets, the impact to investors will be mixed. Here are the three main ways I see lower Treasury yields (higher prices) affecting investors going forward:
1. Mortgage Rates Will Likely Fall: Declining yields on longer dated Treasuries will most likely drive down mortgage rates even further. Those in the market to buy a home should take advantage of these low rates over the next 12-18 months before the Fed acts.
2. Income Generation Will Get Tougher: Falling yields will make income generation even more difficult, and income seeking investors will need the help of an active manager to navigate the added risk required in a portfolio to find attractive yields.
3. The U.S. Dollar Will Get Stronger: Since our debt is so attractive on a relative basis, foreign investment should continue to come to the U.S., which will strengthen our dollar even further. Investors who are thinking of visiting Europe should benefit in 2015, as the Euro and U.S. dollar approach parity.
The bottom line is that demand for U.S. debt should exceed supply for the foreseeable future, which will drive Treasury prices up and their yields down. Since so many financial assets use Treasuries as a base for their own value, we expect the yields in several sectors of the bond market to also follow suit.
Therefore, we have positioned our conservative portfolios to benefit from falling Treasury yields for 2015, and we will be watching the interest rate environment very closely and adapt as we approach the day when the Fed finally enacts the first rate hike since 2006.
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