Treasury Yields Will Stay Lower Longer Than Expected
05/13/2014 12:00 am EST
Yields at the long end of the Treasury market, says MoneyShow's Jim Jubak, will likely be higher at the end of 2014.
So far, supply and demand have trumped central bank balance sheets when it comes to long-term interest rates.
Even as the US Federal Reserve has grown its balance sheet to $4.2 trillion in April 2014 from $488 billion in January 2011, yields on 10-year and 30-year US Treasury bonds have stayed extraordinarily low.
The reason? An extreme shortage of supply that has made buyers who need long-maturity bonds to match long-dated obligations willing to pay up.
Excluding those 10-year and longer Treasuries held by the Federal Reserve itself, Treasuries due in 10 years or more account for only 5% of the entire $12.1 trillion market for US debt. Pension funds faced with new regulations that require them to buy more long-dated Treasuries and overseas demand have pushed down yields on 30-year Treasury bonds to just 3.46% as of May 9. The yield on the 10-year bond, after dropping below 2% in September 2011 and effectively staying below 2% until June 2013, has since climbed back to 2.86% in January 2013 before retreating again to 2.62% on May 9.
Feeding the supply/demand imbalance has been a big drop in net issuance of US Treasuries. Net issuance of Treasuries is scheduled to drop by 36% in 2015 from the 2013 level.
It hasn't hurt demand that despite their low yields, US Treasuries still yield better than competitor products such as the 30-year German Bund with its 2.34% yield.
Strangely enough, the recovery of the US economy and the strong 32% return from stocks in the Standard & Poor's 500, have increased demand for long-dated bonds too. Thanks to last year's gains, pension funds look a lot healthier than then did in the worst of the global financial crisis.
The 100 biggest US corporate pensions moved up to 88% funded by the end of 2013, their best showing since October 2008. That has let them cut back on risk-hold less in equities-and concentrate on matching the maturity of future obligations with long-dated Treasuries. For example, the $16.3 billion pension fund at Caterpillar (CAT) has increased its debt position to 35%, the most in at least a decade.
The strong demand for Treasuries and the limited supply has made the longest end of the Treasury market a very rewarding place to be in 2014. The return to holders of the 30-year Treasury has been 12.3% in 2014 to May 8.
With inflation in the United States running at an annual 1.5% in April, bond investors are willing to buy 10-year and 30-year paper with a real yield of just 1.12% or 1.96%, respectively.
The big positive return in 2014 to date doesn't mean this is a one-way trade. In 2013 holding a 30-year Treasury resulted in a loss of 12.5%.
And bears have been predicting an increase in interest rates pretty much every year since the Fed started to grow its balance sheet. And 2014 is no exception. Predictions are that the yield on the 30-year bond will climb to 4.14% by the end of 2014. That would produce a big loss for owners of 30-year bonds.
The speed of any increase in yields (and remember that bond prices fall as yields climb) depends on how fast (if at all) growth picks up in the US economy and how much yield-insensitive demand there is at the long end of the Treasury market. The Bank of Nova Scotia estimates that buying from private pension funds will create $150 billion in demand for longer-dated Treasuries in the next 12 months. That compares, the bank calculates to $40 billion in demand from pension funds in 2013.
My read on how this all balances out suggests that yields at the long end of the Treasury market will indeed by higher at the end of 2014 than they are now but that once again Treasury bears are likely to be surprised that yields haven't climbed higher and faster than they have.
Scarcity will continue to count-even as the Federal Reserve reduces its monthly purchases of Treasuries for the remainder of 2014.