With the 10-year Treasury yield (^TNX, IEF) testing a critical technical and psychological support level at around 2.0%, many are wondering: How low can 10-year Treasury yields go?
In part one of this series, I will inquire: Could 10-year Treasury yields ever fall below zero? Or is zero an absolute lower-bound limit for 10-year Treasury yields?
Death, Taxes And 10-Year Treasury Yields Above 0%
It is often said that there are only two certainties in life: Death and taxes.
I would add one other proposition: 10-year Treasury Bond yields will not fall below zero. Indeed, I believe that this proposition is even more certain than taxes.
Before 10Y Treasury Bond yields go below 0% there will no U.S. Treasury, and no taxes.
10Y Treasury Bonds And Money Markets
Some investors may retort that yields on short-term Treasury securities have registered negative yields on several occasions in recent times. Why couldn’t his happen in the case of 10Y Treasuries?
In a panic, yields on short-term government securities can and do become negative for very short periods of time as investors liquidate risky investments in exchange for money. Sub-zero rates can arise briefly because money market funds that receive this liquidity must invest the proceeds in money market instruments. Money market instruments are, by definition, highly liquid short-maturity instruments. They are “money substitutes.” Therefore, excess demand for these instruments can cause their price to be bid up to the extent that the yield on the instrument becomes negative.
However, it is important to understand that money market funds and other investors searching for places to store liquidity do not and will not purchase long-term Treasury bonds at negative nominal yields.
People that need to safeguard cash are looking for two things: First, they demand guaranteed principle integrity. Second, they demand instant liquidity. The rate of interest paid is a secondary or tertiary consideration in money markets.
Long-term Treasury bonds do not meet the criteria demanded by money market investors. Long-term Treasury Bonds are not money substitutes because of their long maturities and the associated risk of loss on principle.
Could a crush for liquidity ever reach the extent where money market investors were forced to climb the maturity ladder to avoid extremely negative rates at the short end of the curve? No. There are two reasons for this.
First, the sale of non-money assets for money is always a zero sum transaction as far as the supply and demand for money and money substitutes is concerned - i.e. somebody must part with their money (i.e. withdraw a deposit or redeem shares in a money market fund) in order to pay the seller of the non-money asset. This means that the total net demand for money market instruments cannot really be altered very substantially. The only major exception to this basic observation arises if the Fed expands the money supply dramatically to meet the massive new demand for money. This possibility will be addressed below.
Second, the U.S. Treasury would not allow the demand for money to substantially exceed the capacity of money markets to absorb that liquidity. The Treasury, in coordination with the Fed, would issue as many short-term Treasury securities as would be required to equilibrate the supply and demand for money market instruments. Thus, even if the Fed provided new liquidity to panicked investors selling non-money assets, the Treasury would meet the corresponding demand for money-market instruments by issuing short-term Treasury securities.
The Prospect Of Deflation
What of the possibility of severe deflation? Is it not possible that the prospect for severe deflation could prompt long-term bond investors to accept negative nominal yields knowing that their return could be positive in real terms? No.
First, there is absolutely no historical precedent for investors accepting negative nominal yields for long-term debt securities.
Second, nobody can reasonably believe that the U.S. Fed will ever allow deflation for 10 years – or the average rate of inflation over a 10-year period to be negative. As described here, the U.S. Fed will engineer inflation through proverbial “helicopter drops,” if necessary, in order to avoid prolonged deflation.
Conclusion
For any number of reasons cited in this article, and a few others, it is virtually impossible that 10Y US Treasury Bond yields could ever go lower than 0%.
The United States Treasury will cease to exist, and so will taxes, before 10Y Treasury yields decline below 0%.
Zero is an absolute lower-bound limit for 10Y Treasury yields. This proposition can be stated with as about as much certainty as the maxim regarding death and taxes.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am short TLT and long TBT and SBND.
