Outlook for Treasuries
by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM
I’ve been getting numerous questions since last Friday’s employment report as to whether my Treasury view has changed. I wrote the following to my sales team early this week that I now share with you.
The bottom line: I remain steadfast in my view that 10’s and 30’s will hit an all-time low yield in 2016, regardless of Fed action.
Below is what I wrote on January 4th (“The Bond Awakens” note which is attached). Its explains the demand for long Treasuries. For the time being, I continue to stand by all of these factors.
• There still remain strong arguments for owning long-dated Treasuries. The reasons are fundamental, technical, Pension-related, relative, fiscal, regulatory, and due to the Fed’s balance sheet management.
• Fundamental – Economists frequently forecast 10-year Treasury yields by adding expectations for growth and inflation rates to a risk premium. This formula has been unreliable in recent years. Poor understanding of factors such as globalization, innovation, indebtedness, and demographics has led to chronic over-estimations. The business cycle might now be turning lower just as the Fed is hiking.
• Technical – The Fed owns around 40% of all Treasuries 10 years and longer. The ECB is buying 2X the amount of net issuance. The BoJ remains in full QE mode. There might be a shortage of long dated high-quality collateral.
• Pension Demand - Moreover, since 2008, the Pension Benefit Guarantee Corporation has doubled its ‘per participant premium’ and tripled its ‘per unfunded vested benefits (UVB) premium’. These premiums rise on January 1st every year through 2019 and are scheduled to rise by another 25% and 30% respectively. The UVB motivation is to encourage Liability Driven Investment (LDI). The potential demand by the $3.2 trillion in corporate DB plans could be massive and have a profound impact on long Treasury securities.
• Relative – The US 10-year yields more than Germany (164 bps), France (128), Italy(67), Spain (50), Norway (85), and Japan (197). It yields 60 bps more than Slovenia and has the same yield as Bulgaria. In a highly globalized world, sovereign yield differentials among developed world economies may be more limited than in the past. A strengthening USD also increases its relative attraction.
• Fiscal – The US fiscal deficit has fallen dramatically. Net coupon issuance is expected to fall around 25% to the lowest level since 2008. Without any debt ceiling limits to worry about and due to money market reform needs, the Treasury will be funding a larger amount of its budget deficit with Bills (whose issuance as a percentage of outstanding debt is at the lowest level in almost 20 years).
• Regulatory – New capital rules (i.e., LCR) have incentivized banks to move toward more liquid securities with limited credit risk components.
• Balance Sheet – The Fed has approximately $215 billion of Treasury securities that mature in 2016 which it will be reinvesting across the coupon curve at auctions. This amount will be the equivalence of 10% to 15% of the entire gross new issuance of Treasuries in 2016.
Economist still want to predict long Treasuries by the formula: 10yr yield = growth + inflation (+/-) risk premium. This formula is dead for now.
TV anchors and their guests fail to understand the reasons driving long rates. They have less to do with inflation and more to do with demand. FOMC member also misinterpret what low rates mean and what are driving long Treasuries to higher prices (lower yields).