Resilient Treasuries

Despite all the concerns over higher interest rates, Treasury yields managed to decline further in the latest week, with the 10-year Treasury note yield dropping to 3.45%, the low end of a nearly two month trading range. The drop in yields is more impressive considering it occurred in the face of  better than expected economic data, further improvements in key liquidity measures, a fresh dose of record Treasury supply, and another week of  higher stock prices. Any of these factors, let alone all, would normally have been enough to push yields higher given light summer trading conditions.

10 Year Treasury Bond Rates Perplexing

Investors would not have been misguided to have expected Treasury yields to rise last week. The S&P 500 added another 0.25% on top of the  prior week’s 2.2% gain. Economic data, on balance, continued to surpass expectations. In the most recent week, both the S&P/Case-Shiller Home Price Index and the Federal Housing Finance Agency House Price Index showed gains in average home prices for the second consecutive month. New home sales and consumer confidence surpassed expectations, and the durable goods release pointed to a sharper than expected rebound in business spending. Finally, while Q2 GDP was unrevised at -1.0%, a bigger than expected inventory draw-down bodes well for future economic growth. Rising Treasury supply proved again not to be problematic, even with lower overall yields. Another dose of record supply was easily digested as the Treasury sold $109 billion in new 2-, 5-, and 7-year notes. Also, a key measure of liquidity we often consider, the TED Spread, showed steady improvement again by declining to 0.21%, its lowest level since February 2007. The lower spread reflects less risk in the banking system.

Why the resilience?

Most importantly, benign inflation has helped support the Treasury market. Core CPI for July declined to 1.5% on annualized basis. Bond investors focus more on this measure rather than overall CPI, which includes volatile energy and food prices. Core CPI is expected to decline slightly through yearend, which is favorable for bond holders. The benign inflation view recently received a lift from the demise of Healthcare Reform, which was expected to add $1 trillion to the deficit. Although the bill might be revised, reduced pressure on the budget deficit was a relief for Treasuries investors already worried about new issuance.

On a secondary note, the message from central bankers at the Federal Reserve’s annual retreat in Jackson Hole was that current monetary stimulus  would remain in place for some time. Central bankers appeared in no hurry to remove stimulus too soon and seemed to suggest interest rates would  remain on hold longer than reflected in current market expectations. Fed Fund futures indicate the Fed will fi rst hike interest rates in 2Q10, while  economists’ consensus expects the first hike to occur in late Q3 to Q410. Since inflation and central bank policy are the two main drivers of interest rates, good news on both fronts helped Treasuries.

In mid-August, Treasury International Capital System (TICS) data revealed healthy buying of Treasuries by foreigners. Brazilian central bank President
Henrique Meirelles boosted support for those sales by stating last week that Brazil was rebuilding Treasury holdings and had “no set policy” to move  money out of Treasuries. The Treasury market welcomed the news; Brazil, the fourth largest foreign holder of Treasuries, had been notably absent from  Treasury purchases in 2009.

The Head of Fed Extended

Finally, Fed Chairman Bernanke’s reappointment to another term, while expected, had a calming effect on Treasuries investors. Market uncertainty  is usually priced in via higher yields, and had a surprise occurred, Treasury yields would have likely spiked higher.

This week, a heavy slate of economic data and the release of the minutes of the August FOMC meeting pose several potential challenges to Treasuries.   Given the market’s indifference to economic reports recently and a benign Fed, the Treasury yield range will likely persist, allowing interest income to  be the driver of returns as September begins. The range bound Treasury environment has helped the bond market achieve a year-to-date total return of 4.2% through August 28, as measured by the Barclays Aggregate Bond Index. Interest income has played a greater role for high quality bonds, which are more sensitive to interest rate movements, thanks to the price stability provided by the range bound environment.

We believe the range bound trading environment, defined by a 10-year Treasury yield of 3.3% to 4.0%, will continue over the near term and keep  the bond market on track to meet our forecast of a mid to high-single digit total return that we reiterated in our 2009 Mid-Year Outlook. As we approach year end, the top end of the yield range may again be tested as investors gauge 2010 inflation prospects and assess the proximity of a possible Fed rate increase. At that point, expensive Treasury valuations will be difficult to maintain if either risk increases. Absent significant changes to either over the near term however, Treasuries will likely stay in a range and interest income might become a more prominent driver of performance going forward. However, because of the longer-term risks, we are cautious on Treasuries and remain underweight.

IMPORTANT DISCLOSURES

  • The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
  • Neither LPL Financial nor any of its affiliates make a market in the investment being discussed nor does LPL Financial or its affiliates or its officers have a financial interest in any securities of the issuer whose investment is being recommended neither LPL Financial nor its affiliates have managed or co-managed a public offering of any securities of the issuer in the past 12 months.
  • Government bonds and Treasury Bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fi xed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
  • The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
  • Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
  • High Yield/Junk Bonds are not investment grade securities, involve substantial risks and generally should be part of the diversifi ed portfolio of sophisticated investors.
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