Thursday, April 22, 2010

Treasury Yields: The New Equation

Recently, in this space, we criticized the view expressed by Morgan Stanley, that 10-year Treasury yields are headed for 5 1/2% this year, as too simplistic because it was relying heavily on the argument that the government's massive borrowing needs will inevitably push yields sharply higher. The behavior of Treasury yields in recent days warrants revisiting briefly this topic.

After briefly piercing the 4% mark earlier this month, the 10-year Treasury yield has returned again comfortably to the middle of its 3.60% to 4% range that has prevailed since the beginning of the year. On the face of it, such a resilient performance runs contrary to the general perception that strengthening economic activity and an unprecedented (and relentless) onslaught of new supply can become key drivers for Treasury yields. Those factors, although analytically intriguing, have a very mixed track record in terms of validating what is expected of them- and this is so even in relatively "normal" times.

But the current environment is all but normal. It is dominated by a set of complex factors, originating from multiple sources, which, hard as they are to incorporate into any model with the well-intended ambition to forecast interest rates, do nonetheless play a pivotal role in affecting Treasury yields.

A low-grade anxiety over the Greece fiscal saga that continues to reverberate within global financial markets and its implications for the Eurozone, compounded by the headlines related to the Goldman affair have again reasserted the prominent role of Treasuries as the place to be in periods of uncertainty. As a result, they have decidedly trumped any uneasiness over the increasing credibility of the economic recovery and record issuance of government debt. So much so, that a string of solid economic data in the last couple weeks and the Treasury's announcement today that it plans to sell a record of $129 billion of Treasury securities (including $11 billion TIPS) next week, have failed to disturb the solid underpinning of the Treasury market in this environment.

All in all, even the broader, more classic, fundamentals are not that hostile to Treasuries either. Strengthening economic data are not inherently negative for the Treasury market but only to the extent they are viewed as a proxy for future inflationary pressures. However, with core inflation continuing to drift lower- the direct result of both the great inertia of price trends and the huge amount of slack to be absorbed from the last recession- and the Fed squarely reassured by such a benign inflation dynamic, the steadily firming economic data are non-threatening to the Treasury market.

Long-term Treasury yields will ultimately break-out of their 40-basis point range so far this year; this is, after all, an unsustainably narrow range over a longer period. However, the risk is about even that such a breakout in yields will occur on either side of the range. Intensification of the uneasiness over the Eurozone fiscal situation, or a technical correction in the stock market, can cause a breakout to the downside, while the opposite is likely if things are uneventful on those two fronts and the monthly payroll data pick up steam unexpectedly reigniting more visceral fears among Treasury market participants.

For the time being, until something significant changes in the configuration of the current environment, the 4 to 4 1/4% zone for the 10-year Treasury yield needs to be approached as a buying opportunity.

One would like to think that, setting aside the short-term noise, fundamentals will ultimately reassert themselves as the main driving force for long-term yields. This brings up the need though to expand the menu of fundamentals to be considered in an environment where there are multi-layered forces influencing Treasury yields. Supply and economic data alone are just not enough any more.

Anthony Karydakis