Why I'm Not Running To Treasuries

by: Vahan Janjigian, CFA

What do you think has been the most surprising development in the markets so far this year? The collapse of oil below $30? The 11.3% selloff in stocks?

I would suggest another candidate: the plunging yield on longer-term U.S. Treasury notes and bonds, particularly the 10-year.

Investors pay particular attention to the 10-year Treasury note because it is an important benchmark. Mortgage rates, for instance, are often pegged to the yield on the 10-year Treasury note. And it makes up the core of many a retirement income portfolio.

So, it seems particularly odd that this benchmark interest rate is falling, and falling hard, so soon after the Federal Reserve increased the Fed Funds rate for the first time since 2006.

To appreciate what's going on, you have to realize that there is an inverse relationship between bond prices and interest rates. When bond prices increase, the effective interest rate, or yield, decreases. Because that's been happening lately, it's a good time to ask why.

There are three possible explanations. The first has to do with simple supply and demand. If the government is not issuing enough longer-term debt securities, demand might exceed supply and the yield would fall as investors bid up the price. But the U.S. government is happy to borrow, so that's not a likely explanation for the recent drop in yields.

A second explanation has to do with investors seeking safe havens. When investors worry about holding riskier assets, they look for safer places to invest their money, and U.S. Treasuries are considered to be the safest of the safe havens. In this scenario, investors don't buy government bonds because they like the yields. They buy them because they are worried that riskier assets, such stocks and commodities and higher-yielding corporate bonds, will do worse. They would rather settle for something close to a 0% return with certainty than take the risk of getting a negative return.

Here's one more possible explanation, and the most intriguing. Investors may have lost confidence in the Federal Reserve's ability to effectively manage monetary policy. The Fed brought us several rounds of quantitative easing and extremely low interest rates in the hopes of boosting economic growth. Those policies didn't help the economy much, but they certainly pushed stock prices higher. Investors also know that the Fed had several reasonable entry points within the past few years to gradually normalize monetary policy, yet each time the Fed failed to move. With all the global uncertainties, and with many central banks in other countries easing monetary policy, investors are not at all sure that the Fed is doing the right thing by tightening at this particular moment.

The Federal Reserve increased its target for the Fed Funds rate on December 16 of last year. The 10-year Treasury note was yielding 2.30% at the time. At last look, the yield had plunged to just 1.87%.

It's been fashionable for a number of years to say that the Fed is clueless. Yet, until now, even many of those who scoffed at its judgment still tended to construct their portfolios around its behavior. The fact that investors are now driving down longer-term interest rates, while the Fed is raising short-term interest rates suggests that it has, indeed, lost credibility.

It also raises the ugly possibility of recession. To understand why, you have to be familiar with the yield curve, which is a graphical snapshot of how current interest rates differ as you move from short-term to long-term debt securities. The yield curve for Treasuries usually has a fairly consistent upward slope. That tells us investors demand a higher rate of return when they invest their money for a longer period. For example, they might settle for a 2% annualized return from a bond that matures in five years, but they might insist on a 3% return from a bond that matures in 10 years. That makes perfect sense. In fact, the yield curve is upward sloping most of the time.

But now, with short-term interest rates going higher and long-term rates moving lower, the yield curve is getting flatter. This means investors aren't demanding much of a premium to tie up their money for longer periods.

Although it rarely happens, the yield curve sometimes inverts. This means that shorter-term notes actually yield more than longer-term bonds. Economists believe this to be a very ominous sign. They say that an inverted yield curve signals a pending recession.

There's no doubt we will have another recession some day. But I'm not yet worried about a recession in the near future. I'll admit that the yield curve is flatter today than it was just a few months ago, but it is still upward sloping. Furthermore, a number of other key economic indicators are still moving in the right direction. Consumer spending, for example, weakened a bit in the fourth quarter of 2015, but it still increased 2.2%. New home and existing home sales are way off their peaks, but both are still climbing. And while we can question the quality of new jobs that are being created, total employment continues to increase. There are no guarantees, but it would be extremely unusual to have a recession when all of these indicators are telling us otherwise.

Given the sell-off we've had in the stock market since the start of this year, I'm more comfortable putting new money to work in equities now than I was last year. I am not willing to accept 1.87% to tie up my money for 10 years.