Today's 7-year treasury auction went very well. The new 7-year U.S. treasury note drew a yield of 3.005 versus an expected 3.047. The financial media was eager to explain the strength of the auction away. For instance, Bloomberg News credited (blamed) weaker-than-expected existing home sales data for the flight to U.S. treasuries. If one merely looks at the surface, that explanation would appear to be accurate. However, we do not stop at the surface around here.
A dead give away that existing home sales were not the driving force behind the strong 7-year auction is the indirect bid data. Indirect bidders, which includes foreign central banks, purchased 61.7% of the new issue. According to U.S. treasury data, indirect bidders purchases an average of 46.2% of the past seven 7-year auctions. Although some smaller investors may have been motivated to participate in today's auction because of today's existing home sales data. Foreign central banks take a big picture approach to treasury purchases and it is very likely that the majority of today's indirect participation was decided upon days in advance (if not longer) of today's auction.
What do foreign central banks know which would encourage them to continue to purchase large quantities of U.S. treasuries at historically low yields in the face of a strong stock market. The answer is that indirect bidders may buy treasuries, but they do not buy the V-shaped recovery argument.
Foreign central bankers know that U.S. economic growth will be hindered by poor consumer activity over the next several years. They know that problem is not a lack of bank lending, but a rediscovery of prudent lending standard. The U.S. economy (and global economy) has enjoyed ever-cheaper credit and ever-lax lending standards. The party is over folks. Look at all the charts you want, the past IS NOT an indication of the future (man, I sound like a mutual fund). Seriously, one cannot look at past cycles, isolate a repeated trend and automatically assume it has to happen again and again. One must also consider the extenuating circumstances. The Fed is not perfect, but I believe it to be accurate when it states that growth will be modest in the near future.
It is the possibility, if not probability, of muted growth that is keeping long-term yields low, for now. This leaves fixed income investors in a quandary. Overweight the long end and you are caught with your pants down when long-term yields finally move higher. Overweight the short end of the curve and your income stream is so low it is almost impossible to catch up even if one extends out on the curve at a later date at higher yields. We would need Carteresque economic conditions to make market timing rewarding in the treasury markets.
Also, investors should understand the difference between fixed income investments which are interest rate products and those which are credit products. U.S. treasuries are interest rate products as they have no credit risk. Short-term securities, such as T-bills and short-term notes, trade at yield levels which reflect Fed policy. Longer-term yields, such as those found with 10-year notes and 30-year government bonds reflect inflation expectations. If bond investors believe that inflation pressures are going to be mild, they are willing to invest on the long end of the curve at modest yield levels as they do not believe inflation will be present which will erode the value of their fixed cashflows.
Credit products, such as corporate bonds, trade at yields which reflect interest rate projections AND the perceived creditworthiness of the issuer. It is possible for corporate bond yields to behave quite differently than treasury yields. We have had two good examples during the past year. Last year as the banking system was pushed to the brink of collapse, credit spreads for financial companies widened out. This caused corporate bond yields to rise. At the same time, treasury yields fell as the Fed lowered short-term rates and investors bought treasuries across the yield curve in a flight to safety from corporate debt to government debt. Corporate bond yields moved in the opposite direction of treasury yields. This makes some portfolio stress tests useless as they tend to stress a fixed income portfolio for specific moves in interest rates,. Most stress tests cannot account for the behavior of credit yields. Many do not account for the changing shape of the yield curve due to Fed policy and inflation expectations. Long-term and short-term yields more often than not do not move in lock step with each other. In fact, they may not even move in the same direction. Always contact a fixed income professional before venturing into the fixed income markets.
So which market is correct in its forecast for the U.S. economy? Don't bet against the bond market.
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