"Treasuries - As A Relative Asset Class - Look Cheap"

Tyler Durden's picture




 

Via Scotiabank's Guy Haselmann,

Long-duration Treasuries continue to look attractive; a view that I have unwaveringly maintained for the past six months for a variety of diverse reasons.  I am still targeting a 2014 low by the end of the summer (3.29% from May 28th), as well as a sub 3.00% 30-year by the end of the year.

However, active traders should be aware of the 2014 pattern where yields rise at the beginning of each month into the Employment Report, but then (mostly) resume falling for the rest of the month.  In the days leading up to payrolls, traders who own long-dated Treasuries should temporarily hedge via legging into flatteners.

Of all of the various reasons, private pension demand is the most interesting and compelling. Since it is also the most misunderstood, I plan to devote my note on Friday specifically to the topic (traveling until then).  The bottom line is that PBGC rule changes will cause persistent and incremental demand over time that overwhelms net visible secondary market supply.  Concerns about funding status will trump the private defined benefit plan manager’s fiduciary desire to ‘maximize return per unit of risk’.

In past notes, I have discussed how Treasury yields look reasonable on a relative basis to the yields on other large sovereigns.  However, direct comparisons of nominal yields can be tricky, because real yields may tell a different picture, and currency pressures (or FX manipulations) may also contribute.  In this light, I thought it would be prudent - in general terms - to compare the 3.4% yield on the US Treasury 30 year to other assets.

After all, money needs a home.  One fund manager recently said to me, “if I sell some of my stocks, what am I going to buy?”  The need to stay invested is a powerful tool.  However, as investors search for incremental yield, they need to remember to assess if they are adequately being compensated for the risk.

It would be helpful to first remember a few comments made by Yellen during her significant IMF speech last week entitled “Monetary Policy and Financial Stability”.  She said, “I am mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk...such risk taking can go too far, thereby contributing to fragility in the financial system”.  Although she is aware of excesses, she basically said that she will tolerate them and try to contain excesses through macro-prudential tools. The strategy, in short, is ‘pump and regulate’.

I wonder how she defines “excesses” and what she considers financial instability to be.

Various news articles have recently given details about the stellar performance of certain asset classes. Here are a few examples:

  • Iowa farmland has risen over 15% in each of the past 5 years to consecutive all-time highs.  The 32.5% increase in 2010 was the largest annual rise in history.
  • The total of US financial assets as a percentage of GDP is at an all-time high.
  • Manhattan commercial capitalization rates (the expected return from rent) have fallen to 4.4%, which is lower than the 2007 real estate bubble.   Nationwide office space in business districts nationwide has risen to $300 per square foot on average from $147 in 2010.
  • Over 50% of all residential real estate transactions in New York City in Q1 were closed without financing and over 35% were from foreign buyers. Prices are 30% higher in the past year.  For a foreigner, Manhattan real estate can act as a safety deposit box, an insurance policy, or a hedge against a wobbly home currency.
  • Since many purchasers are anonymous corporate structures tied to offshore accounts, there might be some ‘dirty money’ aspects.  Moreover, new Swiss transparency laws have likely incentivized flows into US real estate fueled further by local taxes on capital.
  • The Census Bureau estimates that 30% of all apartments from 49th to 70th between Fifth and Park are vacant at least ten months a year.  (See New York Magazine article from June 29th)
  • French cable-television company Numericable recently raised $11 billion in the largest junk deal on record despite the low (non-junk-like) 4.875% interest rate.  (See NY Times – Everything Bubble)
  • The Japanese 10-year yield is below 0.55%.  Some European sovereigns yield the lowest in history (France 10’s at 1.65%, Spain at 2.7%), while others are the lowest in hundreds of years.  Despite massive monetary and fiscal stimulus, lending facilities, and bailouts, EU growth and inflation are anemic. Valuing EU yields are tricky because of the binary structure. For the moment, it appears that there is a quasi-government guarantee with officials ‘doing whatever it takes’ to maintain the union, thus the convergence of spreads. However, it could unravel quickly should this truth not hold as developments unfold, exposing the potential reckless misallocation of capital of yield-seekers.  

These are only a few examples, but the point is that Treasuries as a relative asset class looks attractive.

As I stated in early commentaries, there are other factors.

Expecting a lower longer-run neutral fed funds rate helps valuation.  Central clearing and increased bank capital requirements have increased demand for Treasuries and resulted in a shortage of good quality collateral (observed by repo fails).  If the PBoC (or BoJ or ECB for that matter) are successful in weakening their currencies, their increased competitiveness with the US would leave them with more dollars which would be recycled into Treasuries. While the front end of Treasuries will be driven by the path of the Fed’s policy rate, the back end will continue to be affected more by geo-politics, international events, and expectations for growth and inflation. Pension demand is the icing on the cake.

Own the long end of Treasuries.

“No problem can be solved from the same level of consciousness that created it”. – Albert Einstein

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Tue, 07/08/2014 - 18:08 | 4937114 Rainman
Rainman's picture

And now introducing our next guest,  we have the JGB30y @ 1.69%.

Cheers ! 

Tue, 07/08/2014 - 18:10 | 4937131 kaiserhoff
kaiserhoff's picture

Yield free risk.  Hooray Beer!

Tue, 07/08/2014 - 18:33 | 4937263 DoChenRollingBearing
DoChenRollingBearing's picture

Not me re Treasuries at this level.  But I do have to give a big H/T to buzzsaw99 for having made the gutsy call to buy Treasuries years ago even until recently.  And, he and the author may continue to be right.

I'll keep my gold, thank you.

Tue, 07/08/2014 - 20:19 | 4937641 WhackoWarner
WhackoWarner's picture

@DoChen

"Not me re Treasuries at this level. But I do have to give a big H/T to buzzsaw99 for having made the gutsy call to buy Treasuries years ago even until recently. And, he and the author may continue to be right.

I'll keep my gold, thank you."

 

Well that is the pat answer here.  Always.  But please tell me what you will do with your stash when all these capital controls kick in.  Retroactive thefts (see Spain retroactive tax of .03%)  and bound to be tax on windfall profits come into play?  Let alone confiscation.  Who will buy your stash?

What good is your gold when it is trapped inside this system that is determined to take it all? 

Tue, 07/08/2014 - 21:33 | 4937959 DoChenRollingBearing
DoChenRollingBearing's picture

 

 

1)  They will not confiscate the gold.  And make it illegal, how's that Drug War working out?

2)  There are ways of getting gold out of the country ot otherwise liberating it.

3)  Bitcoin is VERY EASY to get out of the country.

4)  Who's selling their gold?  And who's telling?

5)  Will they make platinum illegal?

6)  I did not say that you have to stay at the "All Inn", I only own approx. 11% of my net wealth in gold.

Tue, 07/08/2014 - 22:15 | 4938138 Pool Shark
Pool Shark's picture

 

 

Q: What's the best way to ensure the price of something goes up?

A: Make it illegal.

 

[P.S.: What I've been investing in for years: Cash, Bonds, Gold. Not necessarily in that order...]

 

Tue, 07/08/2014 - 18:06 | 4937115 Greenskeeper_Carl
Greenskeeper_Carl's picture

loaning money to a bankrupt institution, no matter the return, or how 'cheap', is a pretty dumb thing to do with your money

Tue, 07/08/2014 - 19:52 | 4937558 WhackoWarner
WhackoWarner's picture

@greenskeeper 

"loaning money to a bankrupt institution, no matter the return, or how 'cheap', is a pretty dumb thing to do with your money"

 

Hey loaning money to your " slum landlord": the crack addict, wife-beating, child-abusing, lazy and arrogant waste of space who inherited the building or stole it. Now that is dumb.  But even paying the rent on the over-priced few rooms he/she deigns to rent to you at inflated prices is dumb.  Let alone paying the cousins and nieces and grandkids who feed into your small space the necessities like light and heat.  And they all deal crack or meth. Plus you have the misfit relatives who guard the halls..now they get a piece as well.  Then you got grandma, who gives to the Church every Sunday and is a pillar of the community for raising all these leeches.  Her crimes are forgotten due to her donations to the plate on Sunday. (Just profits from the scheme that goes back in time.)

Meanwhile you are the only one of this cast of characters who gets up and goes to work every day.  But that is also being taken from you. So now maybe they will rent you space in the garbage bins in the alley.

Yeah I guess it is dumb. And that is where w are.

Tue, 07/08/2014 - 18:12 | 4937134 CrashisOptimistic
CrashisOptimistic's picture

You read the note and you find that emphasis is always on ANYTHING other than the reality of grinding descent and absence of growth.

You watch society decline, you own bonds.  Or farmland.  Bond yields have been falling for 30 years.  What has happened now to generate growth above that 30 yr avg?

Nothing.  No reason the yield can't move onward towards Japan.

Tue, 07/08/2014 - 18:13 | 4937149 PAPA ROACH
PAPA ROACH's picture

...or bullets...

Tue, 07/08/2014 - 18:16 | 4937165 pragmatic hobo
pragmatic hobo's picture

fuck you ... i'll hold cash.

Tue, 07/08/2014 - 18:16 | 4937167 bbq on whitehou...
bbq on whitehouse lawn's picture

Yield may drop in half and the stock market may dubble in price, but what will those who are prices out of food do?

Right now only rotting garbage is given to food banks what will happen when its worth more as compost then donations.

Tue, 07/08/2014 - 18:19 | 4937184 CrashisOptimistic
CrashisOptimistic's picture

You do realize if the yields cut in half that is a huge capital gain for bond holders?

Tue, 07/08/2014 - 18:17 | 4937177 Quinvarius
Quinvarius's picture

So if absolutely anything dumps, they will look expensive?

Tue, 07/08/2014 - 18:24 | 4937213 I Write Code
I Write Code's picture

nutz

Tue, 07/08/2014 - 18:28 | 4937233 fonzannoon
fonzannoon's picture

the best is when they follow a Hasselhoff bullish article with a BofA bearish treasury article.

Tue, 07/08/2014 - 18:27 | 4937232 buzzsaw99
buzzsaw99's picture

i am bullish on USTs

Tue, 07/08/2014 - 18:31 | 4937251 fonzannoon
fonzannoon's picture

you are consistent at least.....

Tue, 07/08/2014 - 18:36 | 4937274 DoChenRollingBearing
DoChenRollingBearing's picture

+ 1, fonz

See my comment above re buzzsaw99 having it right for so long...

Tue, 07/08/2014 - 18:39 | 4937297 Spitzer
Spitzer's picture

Bullish on bullshit. Good job

Tue, 07/08/2014 - 19:44 | 4937544 buzzsaw99
buzzsaw99's picture

I have been right about more than a few things over the years and taken A LOT OF CRAP about it too.

Thu, 02/25/2010 - 22:27 | 246160 buzzsaw99

The countdown to qe2 continues...

 

from wiki: In November 2010, the Fed announced a second round of quantitative easing, buying $600 billion of Treasury securities by the end of the second quarter of 2011.[39][40] The expression "QE2" became a ubiquitous nickname in 2010, used to refer to this second round of quantitative easing by US central banks.

You should read moar, comment less.

Tue, 07/08/2014 - 20:44 | 4937771 buzzsaw99
buzzsaw99's picture

btw Spitzturd - i pulled up the 2 year chart for GLD. Ouch.

Tue, 07/08/2014 - 19:24 | 4937403 socalbeach
socalbeach's picture

The Pimco 25+ year zero coupon ETF is the longest duration Treasury I found.  Assuming 25+ years means 25 years, if long rates drop 1/2% and go from say 3.4% to 2.9% that's a gain of 12.9.% ((1.034/1.029)25 - 1, expressed as a %).  The max gain if long rates drop to zero would be 130% ((1.034/1.0)25 - 1).

That's not chicken-feed but no thanks for me.  I wouldn't short long bonds either though.

(edit: if long rates were to go to 10%, you'd lose 78.7% of your $.)

Tue, 07/08/2014 - 19:28 | 4937496 kaiserhoff
kaiserhoff's picture

(edit: if long rates were to go to 10%, you'd lose 78.7% of your $.)

BEFORE taxes and inflation, because the fuckers would still tax you on the coupon.

Nicely done.  Math matters;)

Tue, 07/08/2014 - 20:09 | 4937633 socalbeach
socalbeach's picture

You might like this then.

In his weekly commentaries, John Hussman often says a 1% change in interest rates changes a bond price by approximately Y%, where Y is the duration of the bond. Here's a simple derivation (for zero-coupon bonds) I made after a discussion with Knuckles a couple days ago.

The formula for a zero-coupon bond is,

R = B * (1+I)Y or B = R*(1+I)-Y

where R = redemption value, B = zero-coupon bond price, I = interest rate (like 0.034), Y= years to redemption. Just take the bond price and compound it for Y years with the interest rate.

dB/dI  = -B*Y/(1+I) (dB/dI is the derivative, or slope, of the graph with the interest rate on the X axis, bond price on the Y axis)

So dB/dI * 0.01 would be the approximate change in the bond price from a 1% change in interest rates.  To get a percentage bond price change, multiply by 100 and divide by B giving,

100/B * (-B*Y/(1+I) * 0.01) = -Y/(1+I) ~ -Y.

 

Wed, 07/09/2014 - 05:28 | 4938655 eishund
eishund's picture

My brain hurts from looking at your complex formula. Need some Vicodin.

Tue, 07/08/2014 - 19:45 | 4937542 Chief Wonder Bread
Chief Wonder Bread's picture

Please don't use that word 'cheap' where price discovery has gone missing.

30 yrs may be attractive however.

Wed, 07/09/2014 - 05:26 | 4938652 eishund
eishund's picture

How to make a potent Powder Keg: Add "Cheap" to "LONG DURATION Treasuries" followed by "Low Interest Rate Environment". Oh wait, make that "NO INTEREST RATE ENVIRONMENT".

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