Scotiabank Asks "Are Treasuries The Only Adult In The Room?"

Via Scotiabank's Guy Haselmann,

Disparaged Treasuries are the Only Adult in the Room

Treasuries continue to do nothing wrong.  My bullish views on bonds over the past several months have been met with stern opposition; however, several are now beginning to question their defiance.  With such in mind, it is worth reviewing once again some possible explanations behind the bid.  There are many reasons to expect their strong performance to continue (particularly over the next week).  The bullets below are in no particular order.

The move below 2.5% in the 10-year has been accompanied with talk of convexity needs by mortgage servicers.  Many expect a larger trigger below 2.3%, but the recent down in coupon trade is evidence of existing duration needs.  However, it is only fair to point out that convexity flows are not what they used to be due to the rise in MBS holdings by the Fed, a decline in REIT holdings, and high premium MBS being mostly owned by the GSEs who now make fewer hedging adjustments than in the past.

A few shorter-term factors include tomorrow’s large month-end index extension of 0.12 years of the US Treasury Barclays Index and the fact that bond funds have registered their 11th consecutive week of inflows.

Looming over the market in the near-term is also next week’s ECB meeting where aggressive action is being anticipated due to well-telegraphed hints by Draghi.  His hints have lowered yields and spreads across all European fixed income markets.   Treasury (nominal) yields which have looked attractive relative to the rest of the world have been dragged even higher recently in sympathy with the move in European markets.

  • For example, the US 10yr yield is 70 basis points higher than the French 10yr, while the US5yr is only 6 basis points lower in yield than the Spanish 5yr.   The Japanese 5yr and 10yr notes yields are 0.17% and 0.56%, respectively, compared to 1.49% and 2.42% (note: all comparisons are nominal yields).

I’ve also written about what Pimco calls the “New Neutral”.  Basically, if the neutral nominal fed funds rate is closer to 2%, rather 4%, than Treasuries remain inexpensive.

It is possible that low global yields are a sign that expectations of future growth and inflation are falling Several weeks ago, I wrote that maybe it was “time to reverse the causality”, where, “rather than assuming that stronger growth will bring higher yields, maybe investors should start asking whether exceptionally low global bond yields are saying something about the long-run state of the globalized economy and/or inflationary expectations (deflation)”.

  • Many new headwinds have arisen in the form of Japan’s consumption tax, China’s attempts to reign-in its massive credit bubble, foreign central bank rate hikes, poor developed world demographics, globalization, Russian sanctions, and higher food and energy prices.  There is also Fed policy where:  QE= risk on.  Ending QE = risk off.

There are several other factors that are unquantifiable, yet whose aspects are compelling enough to deter Treasury shorts and motivate others to cover underweights.

  • The foremost factor is the markets persistent focus on a note that I wrote on March 28th about the changing incentives to corporate DB pension plans. I stated that rule changes will create strong demand for long end Treasuries causing them to trade with commodity like characteristics.  I stated that the bottom line was, “The rule changes to the PBGC means that going forward, private DB plan managers will be driven less by their role as a fiduciary trying to ‘maximize return per unity of risk’, but rather by decisions based more by funding status and regulatory incentives that encourage LDI”.
  • Chinese buying of US Treasuries is another compelling, yet unquantifiable, argument and possible source of demand.  My colleague John Zawada first began discussing this topic last week with a similar story that printed in yesterday’s Financial Times.  According to the Treasury Department, Chinese official holding fell by about $40 billion since last November, but ‘Belgium’ holdings increased by $200 billion.  It is thought that a big foreign investor (China?) has merely switched its custody service to Euroclear which is based in Brussels. The intentional devaluation of the Renminbi this year has resulted in a larger current account, so it makes sense that the ‘extra’ dollars would flow into Treasuries.
  • The FT reported (via Wrightson ICAP analysis) that the drop in official Chinese holdings as a percentage of FX reserves fell from 37% to 32% since November.  However, if you associate the increase in the ‘Belgium’ official holdings to China, then the percentage remains the same at 37%.

“If you’re always trying to be normal, you will never know how amazing you can be” – Maya Angelou