The Battle for 4% on 10 Year Treasury Yields

Not to be outdone by their equity counterparts and Dow 11,000, bond investors are focusing on a milestone of their own: the psychologically important 4% yield level on the 10-year Treasury note. Dow 11,000 fell this week but the 4% yield barrier repulsed the latest assault last week. Similar to Dow 11,000, a 4% yield on the 10-year Treasury has not been witnessed on a sustained basis since before the financial crisis began. The 10-year yield traded above 4% briefly in mid-2008 but has not been above 4% on a sustained basis since late 2007. Over the past ten-months, the 4% yield barrier has been breached on an intra-day basis only twice: last June and on Monday of last week. The defenses around the 4% yield level have proven formidable and have helped mark the high-end of a long standing trading range for Treasury yields.

Investors are watching the 4% yield level as a sign of whether the near thirty-year bull market for bonds is finally over [Chart 1]. A break above 4% might signal to investors that the secular decline in interest rates is over and that the long awaited trend to higher interest rates has officially begun. Technical analysts are watching the downward trend channel in the nearby chart (marked by the two lines) closely. However, the upper end of this channel is approximately 4.5% suggesting that a rise above 4% on the 10-year Treasury yield does not necessarily imply the start of the great bear market for bonds. In fact, in late 1994, early 2000, and in mid-2007, the upper end of the channel provided support and marked a turn to lower yields. The removal of monetary and fiscal stimulus that we expect to create headwinds for the economy and financial markets later in 2010 may spur another decline in yields.

The 30-year Treasury bond

Often referred to as “the long bond”, may provide the first clue as to whether the 4% yield on the 10-year may fall. The 30-year bond is much closer to the long-term support as defined by the upper end of the long-term trend channel [Chart 2]. Technical analysts have targeted roughly 4.8% as the key level. A break above may signal the long-term trend higher in the 30-year rates has started. A move higher in 10-year rates would likely be expected to follow.

The battle for 4% may not be a one-day affair and we may see a 4% ten-year Treasury yield several times in 2010. Both sides of the battle line have their distinct vantage points. The 4% yield barrier was recently reinforced by benign Federal Open Market Committee (FOMC) minutes, still low inflation, and cheaper valuations overall. The recent rise in Treasury yields coupled with low and declining core inflation (as measured by core Consumer Price Index (CPI) put Treasury valuations at their most attractive level since mid-2007 [Chart 3]. Real, or inflation-adjusted yields, are a key valuation barometer for bonds (see the 11/10/2009 Bond Market Perspectives — Keeping It Real). Treasuries also became relatively more attractive to their European government counterparts. The rise in Treasury yields relative to German Bunds caught the attention of foreign investors and helped repel the latest attack on 4%. The greater the yield advantage of Treasuries relative to German Bunds, the more attractive Treasuries are relative to German government bonds.

On the other side of the battle line, record Treasury issuance, stronger economic growth, and the prospect of Federal Reserve (the Fed) rate hikes lay siege to the 4% level. Treasury issuance has so far not been able to penetrate market defenses and last week’s auctions met relatively good demand overall. It may take the heavy artillery of Fed rate hikes to push the 10-year yield above 4% on a sustained basis.

Defense

Ultimately, we do expect the defenses around the 4% yield barrier to fall in recognition of stronger economic growth and eventual Fed rate increases. We would not view the rise above 4% as an alarm to bond investors but rather the reflection that the economy and financial markets have transitioned to a more self-sustaining pace of economic growth. We would view this as a positive sign overall for investors and let’s not forget that 4% is still a relatively low yield by historical comparison. Additionally, low inflation and the potential for headwinds in the second half of 2010 may keep the upward advance of yields relatively gradual. For bond investors, we believe it signals a slower pace of performance as discussed in last week’s Bond Market Perspectives. We still expect the 10-year Treasury yield to finish 2010 in the 4.0% to 4.5% range.

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.
  • Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
  • 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.
  • The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
  • Investing in international and emerging markets may entail additional risks such as currency fluctuation and political instability. Investing in small-cap stocks includes specific risks such as greater volatility and potentially less liquidity.
  • Investing in international and emerging markets may entail additional risks such as currency fluctuation and political instability. Investing in small-cap stocks includes specific risks such as greater volatility and potentially less liquidity.
  • The Barclays Treasury index is an unmanaged index of public debt obligations of the U.S. Treasury with a remaining maturity of one year or more. The index does not include t-bills (due to the maturity constraint), zero coupon bonds (Strips), or Treasury Inflation Protected Securities (TIPS).
  • Consumer Price index (CPI) is a measure estimating the average price of consumer goods and services purchased by households.
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