Quietly and with little attention, the U.S. Treasury markets have been on quite a run since the bursting of the Tech Bubble at the turn of the millennium. Treasuries have long served as a barometer for the risk markets (equities), often dramatically outperforming during periods of economic strife. Their historically inverse price relationship to stocks during such times has served investors well in an effort to preserve capital and find a safe harbor. But the magnitude with which we have seen this meteoric rise in recent years may serve as a warning for investors, in what has traditionally been regarded as a "safe" investment.
To put this in perspective, consider that since January 1, 2000 the total return on the Barclays U.S. Treasury 20+ Year Index is up an astonishing +213.77%, versus a cumulative return of only +23.90% for the S&P 500 TR (through 12/31/2012)! Put another way, the long dated U.S. Treasury Bond has averaged an annual rate of return of +9.19% versus a paltry +1.66% for the S&P 500. Quite a prolonged and dramatic run for Treasuries. (Reference Figure 1)
Figure 1: The Treasury Run 2000-2012
While these returns on U.S. Treasuries are perhaps shocking for some, the true gauge of this inverse relationship is most appropriately illustrated when things are at their worst.
2000-2002: The Bursting of the Tech Bubble
Over a three year period, from 2000-2002, the S&P 500 was down a painstaking -37.61%. Conversely, the Barclays U.S. Treasury 20+ Year Index was up +47.31%. This effectively makes for a spread in return of nearly 85%! Dramatic by any measure. (Reference Figure 2)
Figure 2: The Treasury Run 2000-2002
2008: The Great Recession
Consider further the return disparity illustrated during the Great Recession of 2008. With the S&P 500 down an even -37.00% in a single calendar year, the long dated U.S. Treasury Bond was up an impressive +33.72%. A spread of over 70% between risk assets and those perceived to be "risk-free" in just 12 months! (Reference Figure 3)
Figure 3: The Treasury Run of 2008
2011: Standard & Poor's Downgrades U.S. Long Term Debt from AAA to AA+
2011 was a tumultuous year in the investment markets. We witnessed a devastating tsunami in the world's 3rd largest economy, fears over a potential breakup in the eurozone ran rampant, politicians in the U.S. grappled with the debt ceiling, and then Standard & Poor's came out and did the unthinkable - downgrading the credit rating of U.S. long term debt from its illustrious AAA rating. The world markets were astonished, and many pundits opined on the devastating effects such a move might have on our economy and even the global balance of trade.
The downgrade took place on Friday, August 5th, after investment markets around the world had closed for the week. By the end of trading on Monday, August 8th, the equity markets were in a tailspin. Ironically, despite being the very thing that was downgraded, it was the U.S. Treasury leading the way up; reaffirming its position as the universally regarded flight to safety. Within a month, the Federal Reserve responded by enacting "Operation Twist"; pledging to purchase $400 billion of long term Treasury Bonds. Such a move provided the catalyst for yet another leg up in the Treasury Run, but this time rather than on the backs of traditional market participants - our government would fuel this move.
By year end, with all of the anxiety manifested in the equity markets, the S&P 500 TR finished up a modest +2.11%; not counting dividends the widely followed index was eerily flat. At the same time, the Barclays U.S. Treasury 20+ Year Index finished up +33.84%! So much for the S&P downgrade … Or so we have been lead to believe. (Reference Figure 4)
Figure 4: The Treasury Run of 2011
2012 & Beyond: The Beginning of the Unwind?
As investors, we have certainly been through and witnessed a lot in recent years; some of which many didn't even perceive to be possible. The U.S. deficit continues to grow at an alarming rate, as our elected leaders struggle to come up with a viable long term solution. The massive outperformance of the U.S. Treasury markets are a mere byproduct of fear and the damage wrought on our financial system, and it may not be over yet. But as we move forward, the game may be changing. At some point, the Federal Government will not be there as the buyer of last resort, artificially driving up Treasury prices and driving down yields. As they step away, yields will rise and prices on current treasury bonds will fall; creating a financial conundrum for conservative investors who in recent years have been veraciously buying bonds and selling stocks.
According to Morningstar, in 2012 U.S. investors sold more than $105 billion in U.S. stock based mutual funds and bought an alarmingly high $112 billion+ in intermediate term bond funds. And yet stocks in the U.S. returned +16.00% and bond returns generated low single digits. Is this yet another example of investors following the herd? Certainly our more than decade long run in Treasuries is not sustainable. In fact, despite registering a positive rate of return on the year for 2012, U.S. Treasuries have posted negative monthly returns in 4 out of the last 5 months (Morningstar). Is this the beginning of what may be the great unwinding in Treasury prices? What will happen when the Fed stops backstopping purchases of these securities? No one can say for sure, but after such a wild run, one has to question the long term safety of what has long been regarded as a safe haven.
Figure 5: Beginning of the Great Unwind?
In 2012, our annualized inflation rate was 2.07%(www.inflationdata.com). The yield on a 10 Year U.S. Treasury Bond dipped to an all time historic low of below 1.5% (Bloomberg). Not only do long term investors in U.S. Treasury Bonds face the risk of falling prices at some point in the future, but also the risk that current cash flow may fail to keep up with inflation. In other words, this widely held safe asset may very well provide investors with losses; both today and into the future.
The long held inverse relationship between Treasuries and stocks is not likely to end anytime soon. At some point, when we embark on our next great financial crisis, investors may once again expect the U.S. Treasury to rise to the occasion; providing shelter from the storm. This fundamental relationship provides the functional thesis for tactical asset allocation strategies that employ methods of asset rotation. Such strategies possess the ability to navigate the financial markets in good times and bad, adapting allocations to fit current market conditions - whether "risk-on" or "risk-off". Perhaps this is the new paradigm in an ever changing financial marketplace? But for those who otherwise believe in buying and holding an asset class for the long haul, our Treasury Run may soon be coming to an end.
All statistical analysis of market indices referenced herein provided by Morningstar.