BofA: The 10Y Treasury Is No Longer A "Safe Asset", Here's Why

At the end of his lengthy presentation to DoubleLine investors in January, Jeff Gundlach, who was aggressively pitching commodities at the time, a trade that has since returned double digits, made an interesting observation: he predicted that in the next recession "we won't see a bid for safety out of stocks and into bonds." In other words as stocks tumble we "won't see a bond market rally", which means that bonds will no longer be a "safe asset."

Of course, the best example of bonds acting as safe-haven assets was in August 2011, when S&P downgraded the US AA debt rating, a move which many expected would send yields surging and instead led to a 60 bps plunge in yields as stocks tumbled. Why? Because the Fed was directly purchasing bonds, not stocks.

In fact, the US Treasury's most defining feature for the duration of the central-planning experiment launched in early 2009 by the Fed and its peers, is that it was the safest asset around.

Until now.

As Bank of America's Barnaby Martin writes echoing much of the above, "for years, the US Treasury bond has been seen as the safe haven par excellence – a high-quality asset that would rally in times of market stress and offer welcome diversification for investors’ risky portfolios. Recall that in August 2011, when S&P downgraded the rating on US sovereign debt from AAA to AA+, 10yr Treasury yields actually declined by around 60bp during the ensuing 6w."

But this year, the traditional role of US Treasuries has changed because, as Martin writes, "Treasury performance has been akin to a risky asset. Our US rates team have highlighted numerous reasons for structural upward pressure on Treasury yields, including the Fed’s balance sheet shrinkage, higher US Libor rates and importantly…the jump in the US budget deficit."

So what changed? Quite simply, the arrival of "America (debt) First"

As Martin further explains, for the last year and a half, the US has been at the heart of the populism narrative. But an “us first” political ideology will invariably focus on fiscal spending as a means to placate voter frustrations.

The chart above, first presented last week, shows just how much the US fiscal stance has turned expansionary – and more importantly contrary to much of the rest of the world.

As the IMF highlight in their latest Fiscal Monitor, the US is the only Advanced Economy where debt-to-GDP is set to increase over the next 5yrs. Chart 3 shows the spectrum of debt-to-GDP changes, per country. In the US, the debt-to-GDP ratio is forecast to rise from 108% (end ’18) to 116.9% (end ’23). Contrast this to Germany, for instance, where the IMF see debt-to-GDP declining by over 17% during this period.

What’s driving the expansionary debt dynamics of the US? First and foremost, the increase in spending authority by $150bn (0.7% GDP) per year, for the next two years, coupled with lower individual and corporate tax rates (tax reform) will result in US budget deficits being greater than $1tr for the next 3yrs. Meanwhile, the Congressional Budget Office recently forecast that US federal debt (held by the public) will rise close to the WWII peak over the next decade.

Thus, with such an easy fiscal stance, it is perhaps no surprise then that the US debt-to- GDP ratio will cross some milestones over the next few years. Chart 4 below highlights that US debt-to-GDP is forecast to surpass that of Italy in 5yrs.

And, as Martin ominously reminds us, the supply of Treasuries that the private sector will need to digest will be much greater than during the Fed’s QE era, weighing on Treasury bond performance, and also weighing on bond prices especially if, as some speculate, China may occasionally add to the chaos by selling a portion of its own holdings when trade war push comes to shove.

But if Treasurys are becoming an "unsafe" asset, what is taking their place?

Here BofA global rates strategist, Ralf Preusser, makes a key observation, that the typical haven characteristic of Treasury debt is being hindered by the appealing rates of return on cash in the US. As Ralf writes, historically during periods of market turbulence, money would flow from risky assets (such as stocks) into US Treasury bonds.

But with $ Libor at 2.36%, support for Treasury debt is diminishing (consider that 5yr Treasury yields are 2.84%). In other words, the rise of “cash” as an asset class is altering the traditional allocation decisions of multi-asset investors in times of market stress.

This also confirms what we wrote yesterday: "It's 2-Year Yields, Not 10-Years, We Worry About Most."

BofA's chart 5 highlights this point. Here's Martin: "We show the rolling 1yr correlation between total returns on 10yr Treasury bonds and the total returns on the Dow Jones stock index (daily returns). We overlay this with the evolution of 3m $LIBOR."

Referencing the charts above, the BofA credit strategist notes that "a decade ago the correlation between Treasury bond returns and stock returns was significantly negative (-60%). Treasuries performed their function as a place of safe harbor, and a store of value, around the time of the Global Financial Crisis. But  since then the negative correlation has dwindled and is now just -28%."

Moreover, the chart shows that the changes in Treasury/stock correlation have closely followed the evolution of 3m $LIBOR, as Ralf has pointed out. In other words, higher LIBOR rates have coincided with weaker Treasury/stock correlations.

State Said differently, “cash” has started to become an attractive place to park money in times of market stress, and especially so since mid ’17 – when $LIBOR began to rise more vigorously.

Finally, as chart 8 above shows, the rolling 1y beta between Treasury bond returns and stock returns has also declined since the start of 2017, highlighting the reduced sensitivity of US rates to fluctuations in the stock market.

Martin's conclusion:

The competition from “cash”, therefore, seems to be challenging the traditional safe harbor characteristics of US Treasuries.

To this, all we could add is that as the Fed raises rates, it will progressively make cash the "safer haven" to US Treasury, which will result in even higher yields, and - because the Fed cofuses this with inflation - higher rates, until it hikes too far, too fast and the economy crashes into a recession, or depression.

Meanwhile, all those investors who bought up trillions in "safe assets" - for repo market, collateral posting purposes or otherwise - will be forced to shift their attention elsewhere, most likely Europe where the ECB is still an undisputed "sponsor" of the long end thanks to the ECB's ongoing QE. How that will impact the European, and global bond market, will be discussed in a subsequent post.


blueskyranch Thu, 04/26/2018 - 14:20 Permalink

Well ca$h is King but it can disappear from your bank account at the whim of the Banksters. Keeping it at home is iffy at best. Treasuries are about as safe as any other asset. (of course PMs are best but as we have seen, their price can be manipulated by the PTB). 

Enceladus Thu, 04/26/2018 - 14:28 Permalink

And I'm certain that the highly leveraged rehypothicated steaming pile of shit called a bank will judiciously and fiduciarily keep your pile of 'cash' duely segregated. They promised sealed with a pinky swear.

mydogma Thu, 04/26/2018 - 14:33 Permalink

I love how the financial crises crooks like to give us the low down on how broken and crooked their system is... arrested development....

Harry Lightning Thu, 04/26/2018 - 14:37 Permalink

I can’t begin to describe why this article is absolute academic mental masturbation. Its no wonder investment banks have become loss leaders when they employ economic imbeciles who have no understanding of market mechanics. 

If cash was to become the new safe asset, the assumption thereafter has to be that the cash would be held as such and not invested since all other investments would be less safe. In such case, if return on asset no longer mattered, the cash would go into metals in a very big way. The knock the investment banks always have hit metal investment with is it does not pay interest. But in a world where return on asset is replaced by return of asset, which would investors truly want to hold, fiat currency or a medium that all merchants will accept for settlement of transactions ?

Hence even if these jokers were correct in their prediction of cash being the go-to asset of the future, the next paragraph would necessarily have to state that the cash holding would be a temporary transition state until the cash is invested in investment grade metals. 

The bigger issue is one of market mechanics and cash flows. If the investment community decides in the aggregate that stocks have become too risky and seeks to liquidate some or all of its holdings in that asset class, the sale proceeds of the liquidations have to be put somewhere. The entire world is not going to keep its entire assets in cash, it would be the biggest waste of capital ever contemplated. Accordingly, as capital flees equities, it must go somewhere, and a likely candidate historically is debt. Few markets possess large enough capacity to absorb the trillions that would be leaving the equity markets, but the global debt market can. Which is why at least initially, there will be a huge debt market rally as capital leaves the equity markets.

Only after some time passes and the world is wallowing in a severe economic Depression will market decision-makers decide that the debt has become too risky. In the US, the combination of the existing $20 trillion in outstanding balances owed with the costs of the retirement promises made to the baby boomers and the increased budget deficits that government takes on to provide a safety net to its citizens when the economy tanks, all will work to create anxiety that the US will not be able to ever py off these debts. That credit concern will cause capital to flee the bond market while the economy remains mired in Depression. The US Central Bank will respond by buying the bonds that are being sold, and that will create an Argentinean-type stagflation the likes of which never have been seen.

At that point, precious metals rise through the roof, with the price of an ounce of gold moving up to meet the downward moving price of the Dow Industrial index.

That’s how this mess all will play out, I hope the characters at the B of A are reading.

Harry Lightning Consuelo Thu, 04/26/2018 - 15:13 Permalink

You're absolutely correct, which is why these problems fester so long before they cause calamity. Reminds me of how the banks never learn from their past mistakes, it just takes time enough for everyone who was around for the last catastrophe to be out of the industry. The scary part is that the time to forget the mistakes of the past has shrunk in half now. There used to be a Depression once in everyone's lifetime, as it took that long for people to forget the mistakes of the past. Now it seems that it only takes ten years for people to forget the last mess, as evidenced by how banks today have even more toxic positions in uncapitalized Credit Default Swaps than they had in 2008. Writing insurance policies without capital is lunacy, but that's exactly what goes on every day in CDS...and the government turns a blind eye to it, ensuring the next big crisis.

In reply to by Consuelo

snblitz Harry Lightning Thu, 04/26/2018 - 15:50 Permalink

I made this chart for my Mom which shows how she might have spent $24,000 in 1965 and what it would look like today:

  • housing $24,000 -> $1,500,000
  • gold $24,000 ($35) -> $900,000 ($1325)
  • S&P 500 $24,000 ($86) -> $735,000 ($2636)
  • mattress stuffing $24,000 -> $24,000
  • T-bills $24,000 -> $117,000 (3%)
  • bars of soap $24,000 ($0.16) -> $225,000 ($1.50)

Mattress stuffing (cash) looks like a really, really bad idea.

She chose housing back in 1965.  She hates gold.  I have no idea why.

In reply to by Harry Lightning

Harry Lightning snblitz Thu, 04/26/2018 - 16:26 Permalink

That's really good. Actually, in real dollar buying power, the $24,000 put in the mattress then buys a whole lot less today than it did then, so she would have really gotten killed by the mattress stuffing choice.

A nice new Cadillac in '65 was like $6,000, a quart of milk was 30 cents, and a postage stamp was 5 cents. There probably is a website that lists a whole bunch of items and what they cost back then, which makes you shake your head and ask what happened since. A while back I read that prices in the US doubled from 1865 to 1965, and then doubled again in a much shorter period of something like 1965 to 1985. 

In reply to by snblitz

Harry Lightning 107cicero Thu, 04/26/2018 - 15:06 Permalink

Sadly, investment today has devolved into selecting the best of all evils in most asset classes. Financial markets used to exist in part to bring discipline to profligacy of the politician, who has no compunction against bankrupting the national treasury in an attempt to buy votes. But that role of moral policeman went by the wayside as the newer breeds of investment managers found it was easier to drink the Kool Aid and go with the flow of what Central Banks ordered. Eventually it ends badly, but no one ever thinks that the music will stop while they are still in the game. Which is why the investment world wound up like deer in the headlights the last time the house of cards nearly collapsed. One of these times not even the government printing press will save them, and that’s when the sins of generations of politicians and investment managers will be paid for.

In reply to by 107cicero

Harry Lightning snblitz Thu, 04/26/2018 - 16:18 Permalink

Absolutely. But who made it unsound ? I believe it started with the US coming off the gold standard, because Nixon realized that the costs of the Vietnam War and the Great Society programs of Johnson would require capital far beyond not only the amount of gold that the US had (which was being drawn down by the advent of trade deficits) as well as the total amount of visible gold in the world. 

Once politicians were no longer bound by a gold standard restricting how much money they could print, they soon realized that they could spend and borrow as much as the world was willing to lend them. Soon the US was racking up $200 billion a year deficits and investors still bought their debt securities. Emboldened with this abdication of financial markets to bring discipline to politicians, deficit financed budgets became the rule rather than the exception. The next step was to get the investment community to accept Central Bank monetization of the debt, to which the financial crisis (combined with technology and other measures and lies that kept inflation in check) opened the door.

The only end to this madness will come when there is a loss of confidence in the ability of countries to repay their debts,. Thus will happen when it becomes apparent that countries will have to start borrowing (or printing money through QE programs) just to pay the accrued interest on outstanding debt. That's when the house of cards comes down, and the entire financial system as it is now known collapses. I don;t know what replaces it, but I will bet that this nonsense of faith and credit backing currencies will be a thing of the past. Governments will have to start posting collateral to borrow money, which will result in either a huge reduction in government expenditures, or a complete re-definition of who owns what is now considered to be private property.

The outcome will depend on the willingness of populations to fight against government confiscation of their property in order to post collateral for borrowing. The choice for the masses will be a no win situation - either allow the government a claim to your property so they can borrow money to provide services, or face a significant global depression as GDPs plummet due to the reduction in government spending. That argument at first will seemingly be decided by wealth distribution, and in most countries the wealth distribution in terms of numbers sides with the government taking a claim against private property. There will be more have-nots than haves. However, the democratic solution might very well then be decided ultimately by who has the guns and ammo.

Not going to be pretty....but this is what happens when countries continue to employ foolish policies, and financial markets allow them to get away with them.

In reply to by snblitz

Boeing Boy Thu, 04/26/2018 - 14:50 Permalink

Article fails to join up the dots.  As liquidity dries up there is three times more debt than money to pay, Fed will be faced with collapse or print just as it was in 2018.  It will of course, print, problem solved as you can never run out of zeros...

Boeing Boy Thu, 04/26/2018 - 14:50 Permalink

Article fails to join up the dots.  As liquidity dries up there is three times more debt than money to pay, Fed will be faced with collapse or print just as it was in 2018.  It will of course, print, problem solved as you can never run out of zeros...

Yen Cross Thu, 04/26/2018 - 15:16 Permalink

  The $usd is going to get longs squeezed in the next 12-24 hours.

  Way over extended on the h-4 chart, and May traditionally isn't a good month for $usd.

666D Chess Thu, 04/26/2018 - 16:07 Permalink

The 10 year treasury is not a safe asset because the dollar is going to crash in the not too distant future. There is no need for so many charts when you have common sense. 

Ink Pusher Thu, 04/26/2018 - 16:52 Permalink

A proverbial light-bulb came on at B of A for a few brief moments of cogent thought and higher reasoning and by Monday they'll all be sitting in the dark again...

Let it Go Thu, 04/26/2018 - 18:32 Permalink

I just can't like bonds!

Many of us see the introduction of a single "World Currency" as a major part of the economic endgame. This is something that will be forced on us as part of a "needed reset" to a global economy that has gone off track. If this happens long turm paper promises and bonds would crash.

The new world order and globalization which has been pushed by many world leaders and the rich elite touting that "larger, more cooperative governments under one financial unit will benefit us all” plays into the world currency scenario. The article below delves into how this might unfold.

 http://World Currency Will Be Part Of The Financial Endgame.html