PRINTMarket Update -- In the Markets
September 15, 2009
There are a number of compelling reasons to own U.S. Treasuries right now. Inflation is low and likely to decline further owing to an abundance of excess capacity, making real yields attractive by historical measures. With unemployment approaching 10%, incomes falling, and household wealth down sharply in the past two years, consumer demand isn't likely to drive up core goods prices anytime soon either. Moreover, some of the recent improvements in economic conditions can be attributed to temporary fiscal stimulus policies which will soon fade. Indeed, some of this growth may have been borrowed from the future, leaving the prospects for a consistently strong pace of expansion perhaps a bit tenuous.
There's no question that the economy, though currently growing, remains vulnerable. A large exogenous shock could quickly derail this nascent recovery, and if we falter now our ability to recover again will become exceedingly more difficult. The Federal Reserve and other major central banks around the world have stated repeatedly that they intend to maintain exceptionally low lending rates for an extended period of time, but with the overnight lending rate already near zero, the Fed has exhausted its ability to further ease monetary policy by conventional means. And facing record deficits and growing unease among voters, the Congress won't easily be able to pass yet another stimulus bill or bailout package either. The margin for error is thin, making the safety of U.S. Treasuries a source of comfort for skeptical or skittish investors.
But we can't overlook the fact that the very reason monetary and fiscal policymakers have so few remaining options to enact additional stimulus measures is that their initial response to the credit crisis and the recession was so very aggressive. More importantly, their response seems to be working. Economic growth in the second half of 2009 is tracking well above earlier forecasts and is now beginning to generate its own momentum. The manufacturing sector is seeing an increase in production as depleted inventories are replaced and business spending picks up. Residential construction is also bouncing back as inventories of unsold new homes are gradually drawn down. Labor markets are now beginning to show real signs of stabilization as well, with the pace of job losses having slowed dramatically in recent months.
In the financial markets, credit conditions are easing, liquidity is improving, and stock prices are rising. The progress has been substantial enough that discussions of the Fed's exit strategy have grown quite frequent, and serve as a stark reminder that monetary policy – whether traditional money supply management or nonconventional credit easing and quantitative easing initiatives – can really only go in one direction from here. The only question, it seems, is when will the monetary authorities begin to remove, unwind, or reverse their various stimulus measures?
With respect to the Fed's planned purchases of mortgage-backed securities, agency debt, and Treasuries, the end already appears quite near as completed purchases approach their stated targets, both in scope and timing. Notwithstanding the aforementioned rationale for owning Treasuries, the removal of this massive source of demand for those products at a time when the Treasury also needs to finance a rapidly expanding budget deficit and term out its existing debt may very well shift the market equilibrium towards higher yields.
Thus far, increased Treasury issuance has been met with relatively strong demand, but how long will that last? Treasuries have been able to attract plenty of investor capital because - let's be honest - they haven't had much competition. Issuance of new corporate bonds slowed to a mere trickle in the early part of the year while issuance of new asset-backed securities has been limited primarily to new deals issued under the fed's Term Asset-Backed Securities Loan Facility (TALF). The supply of new non-agency residential and commercial mortgage-backed securities, meanwhile, has virtually disappeared. As for agency debt and mortgage-backed securities, well the Fed has been buying those up faster than the agencies have been making them.
Meanwhile, every month, coupon payments hit investor accounts and maturing bonds return principal, leaving fixed income portfolios flush with cash. In many sectors of the bond markets, the maturities far exceed new supply, leaving holders with limited reinvestment options outside of Treasuries. So while Treasury issuance has ballooned, the increase in public sector borrowing has actually been a natural offset to the decrease in private sector borrowing. A glance at banks' balance sheets confirms this - bank holdings of Treasuries and mortgage-backed securities are at record highs while commercial and industrial loans have been declining.
But now that the wheels of commerce are turning again, corporate bond issuance is picking up and loan demand may soon follow. With credit spreads still quite attractive by historical and relative measures, any increase in private sector borrowing is likely to be well received by the market, but the issuance will have to compete with Treasuries for investor dollars just as the Fed winds down its asset purchase programs. The Fed has been the single biggest net buyer of US Treasuries this year, and once it stops buying, additional increases in supply may not be as easily absorbed by the market. This could be especially true if bank demand slows as well, and if rates rise in response, the banks may then begin to worry more about their convexity profiles. As prepayments slow in response to rising mortgage rates, banks' large mortgage portfolios will extend. Indeed, the mortgage universe overall faces a very asymmetric convexity profile, with low coupon mortgages at risk of eventually becoming long duration instruments when interest rates rise. With the risk of additional duration creeping into mortgage portfolios, the market's demand for additional interest rate risk may decline further, compounding the situation for Treasuries.
Banks and the Fed haven't been the only buyers of Treasuries, however, and there are plenty of other potential sources for demand. One might wonder if perhaps domestic savings and foreign investors can step in to fill the void. Historically, foreign central banks as well as large oil-producing nations have invested heavily in U.S. Treasuries, and a weaker dollar may compel them to increase purchases. Large developing economies like China depend on U.S. demand for their exports to fuel growth, and therefore tend to prefer a stronger dollar. In recent months, however, China has sent mixed signals by indicating that it wishes to diversify its reserves away from dollars. It has even followed up on its rhetoric by buying special drawing rights (SDRs) from the International Monetary Fund (IMF).
American consumers, however, have increased their savings rate, and some of those savings will inevitably find their way into the bond markets, but whether they will be able to absorb the additional supply remains to be seen. Meanwhile, the implications of a weak dollar are impossible to ignore. Massive budget deficits and a rapidly growing public debt have already caused the dollar to weaken substantially, and a political establishment that has shown neither the will nor the motivation to embrace fiscal discipline has further weakened confidence in the dollar. With an economy so reliant on low-cost imports, a chronically weakened dollar will lead to rising import costs and inflationary pressures in many raw materials and core goods.
All of these factors lead us to the conclusion that the risks and rewards are skewed to favor a modestly defensive stance on interest rate risk in the current environment. We recognize that real yields look attractive and that the economy still faces many obstacles, but we also see supply and demand imbalances that we believe will lead to rising yields in the medium term. We have positioned our total return portfolios to be modestly short their benchmarks, leaving scope to adjust higher or lower our duration policy as warranted by evolving economic and market conditions.
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