Treasuries Will Remain Attractive Into 2015

|
Includes: VCLT, VGLT, VGSH
by: Disruptive Investor

Summary

US Treasuries are likely to continue their rally in the first half of 2015 as other developed markets remain unattractive from growth perspective.

The outlook for Treasuries for the second half of 2015 remains uncertain amidst expectations of competitive devaluation of currencies.

Expect portfolio shift in 2015 with overweight ratings for US and India and underweight ratings for Japan, Euro Area and China.

The year 2014 has been a decent year for Treasury bond holders. The yield on 10-year Treasury bonds was 3.03% as of December 2013. Currently, the yields are at 2.28% and the yields have dropped significantly since September 18, 2014, when 10-year bond yield was at 2.63%.

I believe that the rally in Treasury bonds will continue into 2015 and investors can consider exposure to Treasure bonds for the first half of 2015. This article discusses the reasons to remain bullish on US government bonds in the near-term.

Before talking about the bullish case, I want to mention that I am of the view that Treasuries are certainly not a good long-term investment. If the real household inflation is considered, a 2.3% annual yield is disappointing.

Therefore, I am not making a long-term bullish case for Treasuries in this article. I am just of the view that Treasuries will do well over the next 6 months and investors can consider 10-year bonds as a part of their near-term portfolio diversification.

Coming to the reasons, the dollar index has surged from levels of 79 in May 2014 to current levels of 88. The dollar index is currently at its highest levels since March 2009. A stronger dollar is an indication of the relative attraction of the currency against other currencies that make the dollar index.

An investigation on the health of these currencies will back my point on Treasuries remaining attractive in the first half of 2015. While the attractiveness can extend beyond the first half, it is difficult to take a long-term view in an environment where there is constant flow of news that impacts the currencies.

The first reason that supports my bullish view on Treasuries is an uncertain geo-political environment. I believe that Treasuries remain a safe haven in such a scenario and money will continue to flow into Treasuries as it has happened in the last few months.

While the dollar has strengthened in the last few months due to an end to QE, it is also important to note that geo-political tensions have been escalating in the last few months. In particular, Russia's aggressive stance has created additional demand for safe investments. Again, this is not the primary reason, but one of the factors to remain bullish on Treasuries.

The primary reason is how the global economy is shaping up and the investment implications for 2015. My view for some of the largest economies is as follows -

China - The country's manufacturing activity is at a six-month low at 50.0 (HSBC PMI). I believe that the problem with China is manufacturing excesses along with a sub-prime crisis. This will not be solved by cutting interest rates or expansionary monetary policies. According to IMF, China's economic growth will be lower in 2015 than 2014. This makes China an unattractive investment destination in the near-term. I am underweight China for 2015.

Japan - The country's GDP growth remained flat in 3Q14 according to revised data and I believe that the massive stimulus unveiled by policymakers will only flow out of the country into relatively attractive markets and investment classes. The futile attempt to boost the economy is indicated by the Japanese yen, which continues to trend lower. Funds flowing out of Japan will be parked in relatively attractive markets such as US and India. This is positive for the dollar and negative for the yen. I am therefore underweight Japan for 2015.

Euro-Zone - The Euro-zone seems to be in a bigger crisis and I am of the opinion that the region will witness recession in 2015. I had discussed in one of my earlier articles why I expect massive quantitative easing to come in 2015 for the region. Massive quantitative easing implies a weaker Euro and I believe that the Euro will continue to depreciate against the dollar in 2015. If a big quantitative easing is announced this week or in the first quarter of 2015 (very likely), the euro will slump and there will be more fund inflow into dollar.

Weakness in these economies will result in a major portfolio shift in 2015 and I believe that there will be greater portfolio allocation towards US equities and US bonds. Further, Indian equities will also see higher portfolio allocation among emerging markets and China's pain is India's gain.

I must however again emphasize here that the bullish stance on Treasuries is only for the first half of 2015. To me, the impact on the US economy coming from slowdown in these major developed and emerging markets is still unclear. I suspect that the US economy can show some signs of weakness towards the second half of 2015.

Related to the uncertainly for the second half of 2015, if the US economy holds up well, policymakers can potentially increase interest rates in the second half of 2015. This will make the dollar stronger and Treasuries can rally further. However, the probability of this event can be judged only after the economic performance for the first two quarters of 2015 is clear.

I also believe that US policymakers will find it disturbing if the dollar continues to gain in strength meaningfully into 2015. A stronger dollar can impact the competitiveness of US exports and a direct impact will be on export driven companies. In an age of competitive devaluation of currencies, the US policymakers are likely to take action to reverse a strong dollar if the upside continues.

Therefore, there are several contradicting factors that will come into play in 2015 and these factors will keep the markets guessing on the medium-term trend for the dollar and US Treasuries.

For the first two quarters of 2015, the Vanguard Long-Term Government Bond ETF (NASDAQ:VGLT) and the Vanguard Short-Term Government Bond ETF (NASDAQ:VGSH) look interesting. Talking about bonds, I must add here that investors should also consider the Vanguard Long-Term Corporate Bond ETF (NASDAQ:VCLT) for their portfolio with the ETF giving exposure to quality credit.

In conclusion, US Treasuries are likely to witness more rally in 2015 as the US economy is the only bright spot among developed market economies. While the outlook for the second half of 2015 remains uncertain considering the factors discussed, I assign a higher probability to the rally only lasting for the first half of 2015.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.