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Why Are Treasuries So Strong This Year?

May 13, 2014BlogJustin Struble

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Thought for the Week (299):

Why Are Treasuries So Strong This Year?                     

 

Synopsis

·        After the Fed began tapering its bond buying back in December, most investors believed that U.S. Treasury bonds would continue to face pressure going into 2014.

·        To date, quite the opposite has happened as 10-year and 30-year Treasury bonds have delivered very robust returns driven by demand from pension funds, foreign investors, and banks.

·        Although the short-term performance of Treasuries has been stellar, the Investment Committee continues to see the long-term risk-adjusted returns to be unattractive.

Supply vs. Demand

One of the most well regarded economic principles is that markets are governed by the laws of supply and demand. If the supply of a good rises and the level of demand remains the same, then the price for that good should fall.

For example, let’s assume that a bakery in a small town determines that the demand for bread remains constant at 500 loaves per day, and they produce just enough bread to meet the needs of the town. Here supply and demand are in equilibrium.

Then one day a rival bakery opens across the street and sells an identical loaf of bread to the same customer base. The supply of bread available for sale has now increased, however, the level of demand for that bread remains constant at 500 loaves/day. In this instance, supply and demand are no longer in equilibrium, and the price of bread will likely fall over time as the two bakeries compete for a larger share of the 500 loaves/day.

As simplistic as this example may appear, bond and equity markets work nearly identical, albeit much faster. If the supply of bonds available for purchase increases while the demand for bonds remains the same, then the price of bonds will fall immediately to bring supply and demand back to equilibrium.

Back in December, the Fed announced that they would begin “tapering” their bond buying program known as Quantitative Easing (QE), which was designed to keep interest rates artificially low in an attempt to spur economic growth.

The Fed had been purchasing $85 billion of bonds monthly, including a large percentage of U.S. Treasuries, and many investors assumed that Treasuries would fall since so much demand was going to be leaving the market.

NOTE: Just as an increase in supply usually lowers the price for a good, a decrease in demand should also negatively impact the price, assuming the supply remains constant.

Demand for Treasuries was expected to feel even more pressure given that most investors assume that interest rates will rise at some point after the Fed winds down QE altogether. Rising interest rates exert pressure on bond prices, particularly longer dated maturities, so many investors have steered clear of Treasuries for these reasons. In fact, the Investment Committee has also been quite negative on the prospects for Treasuries since 2012 because the risks appear to outweigh any near-term return potential.

U.S. Treasuries Are Flying

The chart below shows the yield for the 10-year U.S. Treasury bond (black line and left axis) and 30-year Treasury (orange line and right axis) since January.

Graph

Yields for both bonds have fallen dramatically, and since bond yields move inversely to bond prices, this downward trend equates to an upward move in bond prices. In fact, investors who have owned the 10-year and 30-year Treasury since January have enjoyed a return of 10.3% and 12.3% respectively.

The big question on the minds of several savvy investors who have been caught off guard by such strong performance is what is driving the price higher given the outlook for interest rates. To answer this very important question, we need to go back to the law of supply and demand.

A bond price rises (yield falls) when either the demand for bonds increases or the supply decreases. Let’s first start on the “supply side” to see if the supply has been rising. The chart below shows the amount of debt issued by the U.S. government since 1994.

Graph 2

The black line indicates the total debt level, which has exploded since the financial crisis in 2008, and the orange line indicates the growth rate for new debt issuance. Although the total amount of debt is rising, the rate at which it is rising has slowed dramatically since late 2009, leaving us with the smallest U.S. deficit in seven years.

According to analysis conducted by Deutsche Bank, net issuance of interest-bearing Treasuries will fall to $545 billion next year, or a 36% decrease from 2012. Simply put, although the U.S. government continues to increase the amount of debt, the rate at which they do so is slowing.

Now the supply side is much easier to quantify than the demand side, but let’s do our best to determine why the demand for Treasuries has seemingly risen sharply. The Investment Committee believes that three main sources of demand have spiked recently:

  1. Pension Funds: New rules designed to plug shortfalls and the selling of equities to lower fund volatility after such a strong 2013 appear to be fueling a surge of demand from pension funds.
  2. Attractive Flight to Safety: Those investors who have near-term concerns over emerging market currencies and instability in regions like the Ukraine have preferred U.S. Treasuries to other ultra-safe government debt because of the relatively attractive yield. For example, 10-year German bonds are also “risk-free” yet pay almost half the yield of a 10-year U.S. Treasury.
  3. Banks: New rules designed to thwart another possible financial crisis has basically forced banks to own more Treasuries because they are considered ultra-safe and can withstand another potential crisis.

Simply put, higher demand for Treasuries has created a surge in price since the pace of new debt creation has slowed.

 

Implications for Investors

Imbalances in supply and demand occur frequently in the short-run and are often fueled by reasons that are not entirely fundamentally driven. Traders may attempt to profit from these opportunities, however, the Investment Committee continues to keep a strict focus on the long-term.

The bottom line is that interest rates will ultimately rise as the economy strengthens, and until Treasuries offer a more attractive risk-adjusted yield, the Investment Committee will continue to urge investors to look past any short-term moves that may appear attractive upon first glance.

 

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This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion of our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private Capital is an SEC Registered Investment Adviser. All charts courtesy of Bloomberg.

                

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