A Coming 'Rout' In U.S. Government Debt?

by: John M. Mason

The Financial Times can really catch a persons attention with a headline like "Flee 'Safe" Sovereign Debt, Says Hasenstab."

The Hasenstab in this case is Michael Hasenstab, who runs a $175 billion portfolio in bonds for Franklin-Templeton. Hasenstab was very successful last year in making "some of the boldest contrarian bets in the bond market…" His interview with the Financial Times was published Thursday morning.

Now, he is saying that you need to be ready for moves in some of the biggest "haven" investments from last year, the sovereign debt of the United States, the United Kingdom, and Germany.

If it were not for the Federal Reserve's bond-buying program, US Treasury yields, Hasenstab argues, would be "higher, meaningfully higher."

"US 10-year yields below 2 percent just don't seem consistent with the US economy."

"The worst has happened and we haven't fallen into a deflation trap."

Further in the interview, Hasenstab says that he in not forecasting exactly when rates will rise but he has already adjusted the Templeton Global Bond Fund in anticipation. And, whereas the typical effective duration of portfolios run by peers in global bond mutual funds is in the five to six year range, Hasenstab has moved the duration of this portfolio to less than two years.

Although right now may be a little premature for the adjustment to take place, Hasenstab argues that "You can't come in after it starts happening."

We have already seen some movement in US yields and German yields. The 10-year US Treasury bond is trading right at 2.00 percent today. In July, this yield was around 1.50 percent. The 10-year German bond was trading around 1.30 percent in early December and is now yielding around 1.70 percent.

Some argue that this initial movement in yields is a result of investors moving more into "risk on" investments, a flight back from "safety" that is needed for financial markets to achieve a more normal structure.

I have argued that this increase in the yields of "safe haven" investments will take place even though the Federal Reserve continues on with its efforts of quantitative easing.

My argument goes something like this. The yields on United States inflation-adjusted bonds (OTC:TIPS) have been negative for almost all of the time that investor have fled to the safety of US Government securities. Today the yield on 10-year TIPs is about a negative 55 basis points.

Since the 10-year US government bond is trading to yield about 2.00 today, one could argue that the market's expectation of inflationary expectations is about 2.50 percent.

Thus, if the movement of investors out of "haven" investments like US government securities brings the yield on comparable TIPS back around zero, then the yield on the 10-year US Treasury security should move up to 2.50 percent.

I have been making this argument since early December. (See "Will Long Term Yields Rise in 2013.") Then I argued, "The point I am getting at, however, is that the TIPS yield plunged below zero as the flight of funds from Europe increased. Therefore, I expect that as Europe improves its financial position, the TIPS yield will return to zero or above. Therefore, if the market estimate for inflationary expectations described above remains around 250 basis points, then the "regular" 10-year United States Treasury bond should yield at least 2.50 percent. I expect it will go a little higher."

This increase, I believe, will take place this year in spite of the Fed's efforts to continue its policy of quantitative easing.

In terms of the financial strengthening in Europe, I find myself in agreement with the Hasenstab interview in the Financial Times: "While Mr. Hasenstab forecasts recession for Europe, he still thinks it will hold together and is more upbeat about the global economy as the effects of quantitative easing by central banks in the developed world are exported to emerging markets."

In my mind, the 10-year rate will only move higher as the TIPS yield moves higher as investors start to build a more reasonable real yield into the structure of interest rates, something more consistent with the expected growth rate of the United States economy.

And, the 10-year rate will move even higher as the US economy picks up speed and the Federal Reserve moves away from its efforts at quantitative easing.

And, where is Mr. Hasenstab investing. Well, he seems to be interested in the carry trade, something that seems to be picking up in activity these days. (See, for example, "Euro Carry Reversal Inflicts Global Pain.")

"In emerging markets such as South Korea (Hasenstab) has been buying short-date bonds paying 2.50 to 3.00 percent, with the prospect of gains from currency movements over time."

"They have an interest rate advantage, so if we look out five years, the value of the Korean won relative to the value of the dollar will probably be higher because we're just flooding the world with dollars," Hasenstab says.

The over-all scenario: the US economy…and the world economy…will continue to improve. The movement of funds internationally, which has already started, will be from "safe haven" countries like the United States and Germany to lesser credits in Europe and to the bonds of the emerging world. Sooner or later, the quantitative easing of the central banks will stop.

The question is one of timing. Hasenstab is apparently starting to move now. And, he cautions, "You can't come in after it starts happening."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.