U.S. Treasuries And The Safe Haven Flows Myth

by: Learn Bonds

On a daily basis, I read about Treasuries serving as the safe haven investment to the investors of the world. If Italian bond yields rise, the financial media reports "investors are piling into treasuries". If political turmoil increases in Greece, Bloomberg and Reuters report "investors are fleeing into US government bonds." If you are worried about the global economy, the implication is that the only logical course of action is to buy US Treasuries.

Being a contrarian by nature, I wondered what would happen if the world suddenly became a safer place. Would a bunch of money suddenly flee the US Treasury market, pushing treasury yields much higher? To explore or "debunk" this idea, I spoke to two bond experts, Michael Pietronico, CEO of Miller Tabak Asset Management, and Brett Wander, Chief Investment Officer - Fixed Income of Charles Schwab Investment Management.

Michael Pietronico, CEO - Miller Tabak Asset Management

My First question: How much lower is the yield of US Treasuries due to them being a safe haven? Michael answered that he believed the yield was reduced by only 20 basis points on the longer end of the yield curve.

What about the headlines that I read about all the money sloshing around? He thought the relatively small moves happening during "risk-on" and "risk-off" days where due to hedge funds putting on and covering short positions in treasuries. These moves were not the result from long-term investors re-allocating assets, the moves came from players already in the markets.

He then explained US interest rates within a global context. Basically, US interest rates were not actually low compared to the world's major economic powers. The 10 year rates for sovereign debt from the UK, Germany, and Japan were: 1.58%, 1.32%, 0.80% respectively. The US 10 year rate at 1.51% seems in fact high comparatively. Michael's primary observation was that the economic cycles of the world have converged. Everyone is wrestling with the forces of slowing economic growth and deflation at the same time. While policy makers, primarily central banks, have a very clear cure for inflation (raising interest rates), the same cannot be said for deflation. The Federal Reserve and other central banks in his opinion are almost out of ammunition for spurring economic growth.

If there was any factor stirring demand for safer assets, it is the potential collapse of the Euro. Michael was very closely watching the Spanish and Italian bond markets. While he did not believe that the situation would naturally resolve itself, he did think it could get far worse. If the Euro collapses, there could be a flight of capital out of Europe into treasuries. In this scenario a 10-year treasury yield below 1.0% is very possible.

I tried to play devil's advocate to Michael's position and tried posit a couple scenarios in which rates could rise. What if China used this opportunity to unload its supply of treasuries or the US experienced another downgrade by the rating agencies? He had great answers for both:

  • The China Question? Where would China put the money? With yields so low globally, a move by China would only provide a buying opportunity for others.
  • A downgrade scenario? He reminded me that during the downgrade of the US by S&P, US treasury rates actually fell and prices rose. He said there was a logic to this. Declining ratings had political consequences and would prevent more fiscal stimulus (government spending), which in turn would lead to lower inflation.
Interview With Brett Wander, CIO - Fixed Income, Charles Schwab Investment Management

Question: Are US Treasury rates lower as a result of the US being a safe haven? Brett answered that he believed that rates were 25 to 50 bps (0.25% to 0.50%) lower on the longer part of the yield curve, maturities over 10 years. As rates for shorter maturities were primarily driven by FED actions, a desire for safety had a minimal impact on that part of the yield curve.

Very quickly in the interview, Brett provided his view on the three forces driving US Treasury rates. In no particular order of importance they are:

  1. The slow growth of the US Economy.
  2. The degree to which the FED is supporting Treasuries.
  3. Europe.

When asked if he thought the FED would do another round of bond buying to keep rates low, commonly described as QE3, he answered that he thought it was "likely". Furthermore, he reminded me that the FED has publicly indicated that they intend to hold rates steady through the end of 2014. This would mean that a rate increase would occur in 2015 at the earliest.

Implicit in Brett's answer about the FED's future course of action were his thoughts about the economy. If economic growth picked up, the FED would not need to do QE3. Thus, he was not predicting a major change in the economy's sluggish pace of growth.

At the end of interview, I asked if there was something else that I should have asked. He mentioned that investors commonly feel that they need to meet specific yield targets. In a low interest rate environment, this means that investors could be tempted to take on more risk than they should. However, he wanted to emphasize that investors should remember to focus on the real rate of return - interest minus inflation. When this is taken into consideration, current rates really don't appear to be out of line.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.