The recent back-up in bond yields, especially in the 10-year U.S. Treasury sector, is both understandable and not scary. Why? The Treasury market is both the highest-quality bond sector to invest in and it is also the most widely used by the hedge-fund, mortgage, and banking industries. These industries invest in Treasuries and they also use these bonds as a hedge against their internal positions, especially when the cost to carry is so minimal.
The U.S. Treasury market is also used by the Japanese and the Chinese central banks to help stabilize their currency levels against the dollar. Therefore, they have been in heavy demand, especially over recent years.
In the early spring, however, the Federal Reserve issued a number of verbal warnings that deflation was not going to be allowed in the U.S. The Fed said it would push rates as low as needed and perhaps purchase long bonds, if necessary, in order to stave off deflation. On this news the bond market continued to rally — but to an extreme.
The 10-year Treasury was yielding around 4 percent in April. It fell in price to a yield of 3.08 percent on June 13. This downward spike occurred over a one-to-two-month period. With investors and hedge funds seemingly positioned for an anticipated federal funds interest rate reduction of 50 basis points in June, and with only a 25 basis points reduction announced (along with a statement by Alan Greenspan that the Fed expected a good GDP recovery in the second half of this year), the new marginal bond investor reacted violently.
And the 10-year Treasury sector took the brunt of the selling — yields rose 110 basis points from the June low. As for the other Treasuries, the 2-year rose in yield by 45 basis points, the 5-year by 95 basis points, and the 30-year also by 95 basis points. This resulted in a very steep yield curve, and the media and brokerage firms started calling for the end of the bull market in bonds. “Sell bonds, buy equities,” was the cry.
The stock market, meanwhile, stopped its three-month rally and started to move sideways. Stock investors recognized that bond yields moving higher ultimately might mean lower valuations, even on better corporate earnings.
So, is the sharp rise in yields a signal to investors that the bond rally of the last twenty years has ended? The new trend of yields is higher, for sure. Right?
No. At least for now.
The Federal Reserve, its open-market committee (the FOMC), and a number of leading economists are currently predicting that even though GDP growth is expected to improve from the 2ish percent trend, inflation is actually going to be lower in 2004 than even the low rate anticipated for 2003.
For instance, the FOMC prediction for real GDP for 2003 is 2.6 percent, and for the Consumer Price Deflator 1.4 percent. For 2004, the estimate is 4.3 percent for real GDP and 1.3 percent for the deflator. So what is the bond market telling us? While no one can see the future precisely — and for the last two years everyone including Mr. Greenspan has been predicting better economic growth — the bond market seems not to be forecasting higher inflation — the U.S. Treasury inflation-indexed bonds, better known as TIPS, have only risen 30 basis points in implied inflation expectations during the same period, with a rise in real return of 80 basis points — but only a rise in the real return, back up to approximately 170 basis points. A 4 percent yield on the 10-year Treasury is right where it should be.
If expected growth ultimately creates more employment growth and some modestly higher inflation, then the short end of the curve moves up sharply creating a flatter yield curve. The 10-year could easily go to 5 percent. If growth does not rise as sharply or as quickly as some expect, then a 3-ish percent level for the 10-year Treasury will be revisited.
So, if you were wise over the years and purchased bonds with yields of over 5 percent, enjoy the income and the joy of a balanced portfolio (hedged between good income from bonds and price appreciation potential on stocks). Of course, I also hope you own at least 50 percent of your assets in common stocks (depending on your age and wealth).
However, there are some potentially dark clouds on the horizon for financial assets, including the bond and the stock market. I do not believe it is any coincidence that the recent rhetoric regarding the 10-year cost of a new health care plan — which attempts to cover prescription costs for the uninsured elderly — is being taken lightly by the financial markets. As we all know, these estimated costs are always low as the years move along, and right now the 10-year estimate is a whopping $460 billion.
Put this on top of a large (but hopefully manageable) deficit estimated at nearly $2 trillion for the 2003-2008 time period, and you have some big issues for both markets to absorb.
The Bush tax cuts are very welcome in this below-average-growth-rate economy. But sanity on both the fiscal and monetary side has to prevail. In a global financial world, both parties cannot afford to play political games as a way to gain marginal votes. Just look at California, where that game was played a little too hard and for way too long. California now has a debt rating close to non-investment grade. Gov. Gray Davis, meanwhile, is probably going to loose his job.
The people’s representatives in government must all recognize that these are not well-balanced times, and that the U.S. is at best in a transitional cyclical phase. Our elected officials must take the high ground, and keep additional federal spending as low as possible, regardless of election cycles. Doing this will go a long way toward securing the long-term health of this nation.
— Patricia A. Small is a partner with KCM Investment Advisors [visit their new site], and is the former Treasurer, University of California.