June 15, 2012
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Dan Shackelford, lead manager of the Core, Core Plus, and Inflation Protected Strategies. |
Treasury yields touched record lows in early June, as investors fled a worsening debt crisis in Europe and a slowdown in U.S. job growth undermined economic confidence. Yields on Treasury inflation protected securities (TIPS) slid even deeper into negative territory.
Many analysts argue that allocations to Treasuries can't be justified at such yields given the dismal U.S. fiscal situation and massive monetary easing by the Federal Reserve. But a case still can be made for including both Treasuries and TIPS in a diversified portfolio, according to Dan Shackelford, lead manager of the Core, Core Plus, and Inflation Protected Strategies. Amid a global shortage of high-quality sovereign debt, he says, Treasuries are more attractive than the main alternatives, such as German bunds and Japanese government bonds (JGBs).
The following discussion reflects Mr. Shackelford's views as of June 11, 2012.
Clearly, a lot of it has stemmed from what's been happening to risky assets in Europe and the emerging markets and other places. We're in another "risk off" period, and the U.S. dollar is still perceived as the global safe haven, even though we are facing the prospect of a decelerating U.S. economy. Plus an economic slowdown typically is also supportive for Treasuries. That's a powerful combination.
You also have to look at what's been happening on the demand side. J.P. Morgan recently reported that purchases of sovereign bonds by mutual funds and banks in the U.S. and the eurozone this year have already exceeded the total for 2011. There's an acute shortage of high-quality assets to meet that demand. There used to be more places to hide from credit risk—Spanish and Italian sovereign bonds included—but the list has gotten a lot shorter.
Right. Even at these yields, Treasuries still look reasonably valued compared to the main alternatives, such as German bunds or JGBs. You can argue that there are better fundamentals in some of the emerging sovereigns. Mexico, for example, is a more compelling fiscal story than the U.S. But the dollar is still the place people tend to run when they are scared.
It's hard to see this as driven primarily by concerns about the U.S. economy. It's significant that corporate bonds have not sold off. While spreads have widened, it's been a passive widening—with corporate yields not falling or not falling as much as Treasuries. That suggests that there's no immediate concern about credit fundamentals. Investors seem to understand that corporate America is still doing an amazing job of defending balance sheets and cash flow. Of course, that's one of the things holding back hiring, but it's reassuring the markets that defaults aren't about to spike.
If the Fed wanted to flatten the entire Treasury yield curve to zero, I think it could orchestrate that. But they understand that there are diminishing returns. At some point, you don't get much added benefit from driving risk-free rates lower. You simply get more of the passive spread widening we're seeing now.
The Fed would probably tell you that they still have alternatives—they could buy more mortgages, or even corporates, if they determined they have the authority to do that. But I think they want to avoid being disruptive in the market. They don't want to get into a position where they are buying what everyone else is selling.
I'm very circumspect about how sustainable these yields are. But you have to look at how we got here and why. If you imagine a hypothetical scenario in which the Fed had done absolutely nothing since 2008—no quantitative easing at all—you can see how yields still might be where they are now because we would still be stuck in a deep recession. So you really can't say it's just the Fed's doing.
You can argue that yields at these levels don't reflect the current economic outlook, but the fact is that there are now huge risk premiums built into asset prices—reflecting the extremely low confidence of investors, U.S. investors in particular. You also have a banking system that has become more risk averse because of new regulations and higher capital requirements. So banks are more inclined to hold high-quality government bonds.
You can make the argument that we have entered a new regime, based on the recognition that the developed world is in a stagnant growth environment, which could persist for some time. The eurozone, Japan, the U.S., and the UK are all struggling to find growth. In that environment, it's plausible that Treasury yields may have moved into a lower range, say between 1.25% and 3% or 3.5% (Figure 1).
The most extreme case would be the zero bound, as we already see at the front end of the curve. Anything below that would be pretty extreme—although we have seen it in the German bund market, where two-year yields briefly went negative earlier this month. That made absolutely no sense, but there may have been technical factors involved, such as institutions that had to own that particular bond.
You can make the case that that is how you are most likely to achieve positive returns in an environment like we saw in Japan in the 1990s—when equities were falling or moving sideways at best. If you look at that period, you'll find that returns on long JGBs remained positive and outperformed equities, even after the 15-year JGB yield had fallen below 2% (Figure 2). So you can talk yourself into it if your outlook is incredibly negative and your view is that just about every other asset class is likely to go down.
I think that's right. There were some specific things that produced—or at least protracted—Japan's lost decade, and hopefully we're not going to see them repeated. But there are strong deflationary pressures working on the developed economies, and that's going to continue as long as the deleveraging process lasts. Japan's experience was a vivid demonstration of what that can mean in terms of downward pressure on yields.
Maybe it's my lack of imagination, but I never would have believed the market would take TIPS negative through 10 years, much less 20 years (Figure 3). I think this is also an expression of the level of risk aversion in the market. There are investors who want to cover themselves against the risk of higher inflation, even if it means locking in a negative real yield. I suppose it reflects a belief that eventually there will be a reckoning—that all this monetary easing will find its way out of asset prices and into the real economy.
Exactly, and the negative yield is like the premium. If you have a strong view on inflation and you believe at some point it will run substantially higher, then you might be willing to pay a premium to be protected from that. And the more uncertainty around the outcome—the greater the volatility of inflation expectations—the higher the premium.
Conceptually, I don't think so. Unlike nominal Treasuries, there is no zero bound. Basically, by accepting a negative TIPS yield, you're saying you expect that real yields on nominal bonds will end up being even more negative. That may sound absurd, but if your base case is that the Fed is going to have a hard time down the road unwinding all this stimulus, it makes a certain amount of sense.
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The views contained herein are as of June 11, 2012, and may have changed since that time.
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