The long vaunted Treasury bear market may already be upon us, with worse to come over the course of the year.
The yield on benchmark 10-year Treasuries moved out to 1.91% last week – the highest level since May last year. The breakout from the trading range of the last five months has been put down to concerns the US Federal Reserve’s commitment to maintaining a loose monetary policy is waning.
The latest set of Federal Open Market Committee (FOMC) minutes from its December meeting revealed an apparent split within the membership. While some advocated the continuation of the asset purchase programme until the end of 2013, others remained in favour without putting a timeframe on the policy.
But others want to either stop buying bonds now or at least end the programme earlier than anticipated.
The minutes said: ‘Several [members] thought that it would probably be appropriate to slow or stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet. One member viewed any additional purchases as unwarranted.’
Gary Dugan, chief investment officer for Asia and the Middle East at Coutts, said: ‘A bear market has potentially broken out in US government bonds, and our favoured response is to continue to rebalance portfolios towards equities.
‘Investors had been happily buying bonds on the basis that the Federal Reserve’s previous communications suggested no tightening of policy until 2015, by which time unemployment might possibly have fallen below 6.5%. However, the latest Fed minutes seem at odds with the view that interest rates will remain low for a long time to come.’
Dugan believes that although in reality the Fed is likely to keep interest rates low for ‘some considerable time’, other forms of monetary loosening are likely to be withdrawn as the economy and labour market improves.
He points out that when the Fed introduced its more accommodative policy after the summer, the economy was in a far weaker position with job creation averaging 66,000 a month in the second quarter, compared to 158,000 in the second half of the year.
‘Fed communications are clearly in a difficult space and we hope Fed board members will use speeches in the coming weeks to add clarity,’ Dugan said.
‘However, the cat is out of the bag as they say, and longer-dated bond yields are on the rise. Bond investors may increasingly be mindful of the losses they are accumulating as yields rise. Ten-year bonds have now lost close to 3% in capital value since early December. Bonds are no longer the one-way winning bet investors have enjoyed in recent times.’
David Roberts, co-manager of the Kames Strategic Global Bond fund, warns that the danger of Treasuries delivering a negative return this year is growing and he backs the consensus view that yields on 10-year paper will move above 2% by the end of the year, but believes capital losses will not exceed 5%.
Wells Fargo Advisors is more pessimistic, with chief macro strategist Gary Thayer projecting that yields will hit 2.5% yield by the end of 2013 against a backdrop of growing uncertainty about the US’s long-term debt and deficit issues. Congress has still to tackle these problems, despite its recent compromise to avoid the fiscal cliff.
‘This last-minute deal was no grand bargain that would have reduced investor uncertainty about many long-term debt and deficit issues,’ Thayer said. ‘Instead, investor uncertainty is likely to persist while the administration and lawmakers deal with the debt and deficit issues in incremental steps rather than all at the same time.’
Although Capital Economics’ US economist John Higgins says this failure to hammer out a meaningful long-term plan to tackle the debt issue could see other ratings agencies follow Standard & Poor’s in cutting the US’s AAA-rating, he believes the outlook for Treasuries remains positive.
He points out the FOMC vow to keep interest rates near zero while unemployment remains above 6.5% (it is currently 7.7%) and the stable outlook for inflation as reasons for monetary policy remaining favourable for US government debt.
‘The upshot is that we continue to expect the yield on 10-year Treasuries to drop back to around 1.5% soon and remain thereabouts over the coming year,’ Higgins said in a contrary call.