Treasury bond yields are a good indicator of several factors related to the economy and the liquidity in financial markets. It is therefore important to keep a close watch on yields for some forward looking assessment. The reason for writing this article is the fact that Treasury bonds have seen a strong sell-off in the recent past with yields on the 10-year bond increasing from a near-term low of 1.85% on April 17, 2015 to 2.37% currently. This article discusses the factors for a 52 basis points increase in bond yield and the likely trend in bond yield in the coming months.
In general, Treasury yield increases with an increase in inflation or in expectation of higher inflation. However, I believe that inflation is not the factor for the recent sell-off in Treasuries. Crude oil has been the key factor for lower inflation in the recent past and oil prices have been largely at the same level from April 17 2015. Further, it is also unlikely that inflation will increase in the foreseeable future due to oil price increase. On the contrary, there are concerns that if the nuclear deal with Iran is sealed in June 2015, oil prices are likely to decline. Therefore, the Treasury sell-off is certainly not a result of higher inflation or higher expected inflation.
In my view, the first reason for the sell-off in Treasuries is a potential end of a 35 year bull market for Treasuries. As the chart below shows, Treasury yield has been trending down since 1981 and I believe that the bull market is finally over with near-zero interest rates.
With the Fed likely to increase rates towards the end of 2015, the reversal of the bull market is imminent. I must admit that I have been wrong in the past on the potential reversal of the bond bull market. But the rally seems extended and I believe that yields are unlikely to trend significantly below 2% again.
Another critical point to note here is that the Greece crisis resulted in investors seeking refuge in government bonds that yield negative returns adjusted for real inflation. With a good probability of resolution of the Greece crisis, I believe that investors will be looking to invest in riskier assets and generate positive returns than remain invested in government bonds. This largely explains the government bond sell-off not only in US, but also in the eurozone.
The interesting point to note is that US equities (NYSEARCA:SPY) are near an all time high and the excess funds from the Treasury sell-off might not find its way entirely to US equities. In my view, industrial commodities and precious metals are depressed and I expect a rally in gold (NYSEARCA:GLD) over the next 6-12 months. Industrial commodities might still remain depressed due to sustained slowdown in China. If the US economy continues to show resilience and if the eurozone economy recovers in the coming quarters, I also expect flow of funds from Treasuries to corporate bonds. Investors can consider the Vanguard Long-Term Corporate Bond ETF (NASDAQ:VCLT).
In general, a strong dollar implies tightening global liquidity and Treasuries rally on a strong dollar. However, with the dollar remaining strong, there has been a relatively sharp sell-off in Treasuries. I am mentioning this point as there can be a further sell-off in Treasuries if the dollar weakens in the foreseeable future and the CPI increases due to weak dollar.
The only factor that can reverse the trend for Treasuries is a sharp economic downturn and I don't see that happening. The GDPNow model from the Federal Reserve Bank of Atlanta is forecasting GDP growth of 1.1% for the second quarter of 2015. Therefore, a recession or continued flat data is unlikely.
In conclusion, the long-term bull market for Treasuries might just have ended and an interest rate hike will confirm that. It would be interesting to see how the government manages its finances amidst rising debt servicing cost. From an investment perspective, diversified investments in risky asset classes might work best.
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