The Case For Owning Treasuries

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The Federal Reserve's balance sheet has expanded significantly since the taper announcement.

Interest rates have over-reacted to the Fed's actions.

Treasuries continue to hedge portfolios against equity volatility.

Treasury bonds are on the top of many investors list of worst future investments. With the Fed slowing their purchases of the securities, the logic says that interest rates must move higher. But for contrarian investors, the data shows a different scenario and a possible profit opportunity.

Overreaction to Tapering

A year ago the bond market suffered a severe reaction with the Federal Reserve's announcement that it was considering a reduction of its bond purchases within the quantitative easing program. The announcement cause ten year treasury rates nearly doubled over the next few months from 1.7 percent to 3.0 percent (Figure 1).

Figure 1: Ten-Year treasury constant maturity rate

Figure 1: Ten-Year treasury constant maturity rate

Last January, after a delay the Fed started to taper their purchases by 10 billion per month. The result of this action is shown in Figure 2.

Figure 2: 2014 Year-to-Date Federal Reserve Bond Inventory

Figure 1: 2014 YTD Federal Reserve Bond Inventory

Looking at the data, it is difficult for the casual observer to look at the expanding bond inventory of Figure 2 and understand the severe interest rate reaction in Figure 1.

Each month, the Fed continues to own more bonds than it did the month earlier. One day the curve will flatten, but currently the inventory is still growing and there are no current plans to reduce the total amount of bonds held. The Fed is simply reducing the rate of increase.

The Feds balance sheet is growing not shrinking. Since the taper tantrum last May the Feds have increased their inventory of mortgage bonds from 1.1 trillion to 1.6 trillion an increase of 45 percent. The inventory of Fed owned treasuries has increased from 1.8 trillion to 2.3 trillion a change of 28 percent.

The rate of increase will slow in the future, but the balance sheet will not shrink. These numbers do not constitute a tighter money policy, nor should they have influence interest rates to the degree that they have.

The Ongoing Bond Shortage

In addition to lowering interest rates, a major effect of Fed bond buying is it creates an artificial shortage of bonds, because the Fed purchased bonds are removed from the private market. Everything else equal a shortage of goods will cause the price to increase. Until last May interest rates correlated with the Feds balance sheet. The more bonds the Fed bought, the lower interest rates went.

Diversion from Trend

This pattern of increasing bond purchases and lower interest rates remained until last May. Since last May's announcement, the Fed's bond inventory is higher, but so are interest rates. The exact opposite of the earlier pattern.

Figure 3 graphs the correlation of Fed assets against the ten-year interest rate, flipped for clarity. This graph shows the recent divergence from the trend. If the divergence reduces and the interest rate reverts closer to the trendline, the interest rate on the 10 year will move one or more percent lower to between 1.5 and 2 percent depending on the strength of the reversion.

Figure 3: Correlation of Fed Assets and Interest Rates(inverted)

Figure 3: Federal Reserve Assets and Ten-Year Treasury Rate (inverted)

Universal Agreement

If the above data isn't convincing, another reason is a contrarian bet. A recent survey announced that 100 percent of the surveyed economist believed interest rates will rise in the near future. That much conviction raises the chance the economist will be wrong.

The Treasury Hedge

Besides trend divergence, the second reason to own treasuries is there ongoing counter action to the stock market. Investors constantly swing from risk-on trades to risk-off trades.

As shown in Figure 4 this behavior allows treasuries to create an interest producing hedge to equity volatility. Having an allocation to treasuries will help lower portfolio draw downs.

Figure 4 shows the beginning of this reversion occurring in the bond market, as the unloved bonds have outperformed stocks so far this year.

Figure 4: Inverse Relationship of Treasuries to Equities

Figure 4: Inverse Relationship of Treasuries to Equities

Investment Considerations

Investors looking for a contrarian trade should consider adding a higher allocation of treasury and government mortgage backed securities.

The best way is to own the bonds outright, but smaller investors can consider unit investment trusts or ETFs (TLT, GOVT, VGIT, PLW) and mortgage bonds (MBB, MBG, VMBS, GNMA) to their portfolio.

This trade will pay off if correlation in Figure 3 reverts to its trend, or just nearer to trend. It will also add a natural hedge to your portfolio, as shown in Figure 4.

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. This article is for informational and educational purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. Please consult your financial and tax advisors before investing.

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