Fed Model for Treasuries Shows Diminishing Returns
This year’s rally in Treasuries has pushed yields so low that a Federal Reserve measure of risk shows U.S. government securities are too expensive.
The financial model created by economists at the central bank that includes expectations for interest rates, growth and inflation shows Treasuries are the most overvalued since the financial crisis in December 2008, just before 10-year note yields almost doubled in the following six months. Investors who held 10-year notes through that period lost 13 percent, according to Bank of America Merrill Lynch index data.
While Treasuries have returned 8.2 percent this year on average, they are down 0.5 percent this month even though Fed Chairman Ben S. Bernanke and fellow policy makers hinted last week they are willing to embark on another round of so-called quantitative easing asset purchases to spur growth and support prices. Investors are concerned yields can’t fall much further without another recession.
“It’s very hard to justify where yields are now, unless we are indeed on the verge of something really awful,” said Johan Jooste, a strategist at Bank of America Corp.’s Merrill Lynch Global Wealth Management unit in London where he helps invest about $1.4 trillion. “We are aware that there is a short-term factor, such as possibility that the Fed might buy bonds. But longer term, you have to ask yourself what you get paid if you hold government bonds.”
The benchmark 10-year note yield fell 14 basis points last week, or 0.14 percentage point, to 2.61 percent, according to BGCantor Market Data. The yield on the 2.625 percent note due August 2020 fell 7 basis points to 2.54 percent at 10:15 a.m. in New York. The two-year yield was little changed at 0.43 percent.
The Treasury plans to sell $36 billion of two-year debt today, the first of three sales this week. It’s also scheduled to auction $35 billion of five-year notes tomorrow and $29 billion in seven-year securities the following day.
The difference between short- and long-term yields signals less than a 20 percent chance of the economy slipping into another recession, according to research from economists the Federal Reserve Bank of Cleveland.
Projections of the three-month Treasury bill to 10-year note curve, using past values of the spread and gross domestic product growth, suggest the economy will expand about 1 percent, Joseph Haubrich, head of banking and financial institutions research at the Cleveland Fed, and Timothy Bianco, a researcher, wrote in a report last week.
“There might be room for Treasury yields to move lower in the near term, but our view is that valuations are moving towards the bottom end of what is likely,” said John Stopford, head of fixed income in London at Investec Asset Management, which invests $65 billion. “Growth is in the process of slowing down, but the bond market is pricing in a 50 or 60 percent chance of a double-dip and deflation. That’s far too high.”
Investec had bought put options on U.S. interest-rate futures, Stopford said. A put option is the right to sell a security at a specific time and price.
The model created by Fed economists Don Kim and Jonathan Wright in 2005 uses forward expectations for the federal funds rate, the 10-year yield, short-term interest rates, inflation and real economic growth rate to calculate the risk of holding longer-duration securities. It is designed to separate basic money-market interest returns from additional yield for longer- term investment. Bernanke cited the model in a 2006 speech in New York as a useful guide in setting monetary policy.
Zach Pandl, an economist at Nomura Holdings Inc., has used the model and made changes for the firm to figure out if the rally in Treasuries had run its course.
After hitting a low in December 2008, at the height of the financial crisis following the bankruptcy of Lehman Brothers Holdings Inc., Nomura’s version rose from negative numbers as speculation about a market collapse faded. Yields on 10-year notes then climbed from a record low of 2.035 percent on Dec. 18, 2008 to an eight-month high of 4 percent on June 11, 2009. The gauge rose to about 100 basis points before yields reached their highs and has since fallen to about zero, Pandl said.
“It’s the first time we’ve seen a negative term premium since the early part of 2009, post-Lehman bankruptcy,” he said. “Other than that time, it was extremely rare.”
Ending Bullish Call
The model recorded a reading of negative 0.18 percent for 10-year debt on Sept. 22, a day after the Fed indicated it may implement additional quantitative easing. It was the lowest on an intraday basis since January 2009.
The drop was one reason Nomura bond strategists changed their forecast on Treasury yields to “neutral,” ending a six- month bullish call.
“Yields have gone too low,” said George Goncalves, head of interest-rate strategy at Nomura, one of the 18 primary dealers of U.S. government securities that trade directly with the Fed. “Incremental easing will not push yields that much lower. It will just keep them at a lower range.”
In March the Fed completed a program of buying $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. The Fed was the biggest buyer of Treasuries when it purchased $300 billion of U.S. debt in 2009.
The first round of quantitative easing lowered the 10-year yield between 50 and 60 basis points since November 2008, said Joseph Gagnon, a former Fed official who is a senior fellow at the Peterson Institute for International Economics in Washington. He estimated a second round would “likely be at least $1 trillion,” and have a smaller market reaction.
‘Go Back Up’
“If they do $1 trillion, the 10-year yield could move 10 to 20 basis points on top of what’s already been done,” Gagnon said. “If they don’t do it, yields will go back up.”
The Federal Open Market Committee’s Sept. 21 statement said it “will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery.”
The Fed’s statement indicates it’s focused on inflation that’s below the preferred long-term range as the main reason to provide additional stimulus. Consumer prices excluding food and fuel costs rose 0.9 percent in August from a year earlier, matching the smallest increase since the 1960s.
The Fed retained its policy, begun last month, of reinvesting proceeds from mortgage debt repayments into long- term Treasuries. It has bought $34 billion since it began the program on Aug. 17. Policy makers also kept the benchmark federal funds rate in a range of zero to 0.25 percent, where it’s been since December 2008, and reiterated the rate will stay “exceptionally low” for an “extended period.”
“Quantitative easing on the basis of past records caused a large decline in yields,” said Wright, co-author of the 2005 Fed paper and a professor at Johns Hopkins University in Baltimore. “If QE is used on a large scale, yields will probably drop even further, and the term premium will decline. If they are just keeping options open, then the term premium will move back up.”
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