U.S. Growth Decoupling From Treasuries Means Record Low Yields to JPMorgan
The strengthening U.S. economy is proving no deterrent to the biggest rally in Treasuries since 2008, and America’s largest bank says it may get even better for bond investors.
U.S. government debt has returned 8.9 percent this year, including reinvested interest, Bank of America Merrill Lynch indexes show. That compares with the 1.8 percent gain in the Standard & Poor’s 500 index of stocks when dividends are included. The rally in Treasuries accelerated since October even as reports showed improvements in everything from consumer confidence to jobless claims to manufacturing.
While government debt usually suffers as a strengthening economy spurs inflation and encourages investors to take bigger risks with their money, this recovery has been different because Europe’s sovereign debt crisis has elevated the stress in the global financial system, bolstering demand for the safest assets. Strategists at JPMorgan Chase & Co. say 10-year Treasury yields, which ended last week at 2.06 percent, may fall toward the record low of 1.67 percent by the end of March.
“As the concern around the euro zone continues to worsen, the money is flowing into the U.S.,” Terry Belton, the global head of fixed-income strategy at New York-based JPMorgan, the biggest bank by assets, said in a Dec. 7 telephone interview. “Even though U.S. Treasuries are rich, at least you know what you have when you buy them, as they are dollar denominated.”
The dollar has appreciated 8.5 percent since its low this year on Aug. 1, according to Bloomberg Correlation-Weighted Indexes, which measure the currency’s performance against the euro, yen and seven of its other major developed market peers.
Cumulative outflows from the euro last week were twice the average in the same period last year, according to Bank of New York Mellon Corp., the world’s largest custodial bank, with more than $26 trillion in assets under administration. The firm doesn’t provide specific figures.
“Europe is the tail wagging the dog,” Dominic Konstam, head of interest-rate strategy at Deutsche Bank AG in New York, one of the 21 primary dealers of U.S. government securities that trade with the Federal Reserve, said in a Dec. 7 telephone interview. The European crisis has led traders to price in more risk to measures of health in the financial system which “haven’t gone away” even with efforts of policy makers, he said.
Yields on 10-year notes rose three basis points, or 0.03 percentage point, last week to 2.06 percent, according to Bloomberg Bond Trader prices. The benchmark 2 percent security due November 2021 rose 14/32, or $4.38 per $1,000 face amount, to 99 29/32. The yield was 4 basis points lower at 2.02 percent as of 1:29 p.m. New York time today.
Yields have fallen from 2.42 percent in October and are below the average of 6.83 percent since 1980 as Europe’s debt crisis, which led to the bailouts of Greece, Ireland and Portugal, threaten to engulf Italy and Spain. Yields on 10-year bonds of Italy, which has more than $2 trillion of debt, ended last week at 6.36 percent, up from the low this year of 4.52 percent in February and above the average of 4.46 percent since 2000.
The European Central Bank cut its main interest rate twice since early November, to 1 percent from 1.5 percent, and the region’s leaders unveiled a plan last week for a closer fiscal union to save their single currency. They agreed to add 200 billion euros ($267 billion) to their rescue fund and to tighten rules to curb future debt. They accelerated the start of a 500 billion-euro rescue fund to next year and reduced demands that bondholders share in losses from rescues.
Even with the moves, two-year interest-rate swap spreads, a measure of stress in the financial system, ended last week little changed at about 42 basis points. That’s more than 50 percent greater than its average this year.
The 120-day correlation between changes in the spread and the 10-year yield reached negative 0.5 this quarter, the highest since Greece sought a bailout in August 2010. Correlations of one mean assets move in lock stop, and negative one signal they move in the opposite direction. As recently as the first quarter, when Treasuries lost 0.14 percent, the correlation was zero.
“In the environment that we’re in, which is fear of Europe, those fears are overwhelming any movement in the economy,” Thomas Roth, a senior trader in New York at Mitsubishi UFJ Securities USA Inc., said in a Dec. 8 telephone interview.
Growth in the euro area economy will probably slow to 0.5 percent next year from 1.6 percent in 2011, while the U.S. likely will accelerate to 2.19 percent from 1.8 percent, according to Bloomberg surveys of economists.
After a July 29 Commerce Department report showed the economy expanded at a 0.4 percent pace from January to March and at a 1.3 percent rate in the following three months, slower than previously reported, the Fed took steps to spur growth.
Policy makers led by Chairman Ben S. Bernanke pledged on Aug. 9 that the central bank would hold its target rate for overnight loans between banks at about zero for at least the next two years and said Sept. 21 they would extend maturities of the Fed’s Treasury holdings by purchasing $400 billion of long- term debt and selling an equal amount of shorter-term securities. That was after buying $2.3 trillion of government and mortgage securities from November 2008 through June 2011.
Manufacturers are now more optimistic about sales, spending and hiring for next year than service companies, a sign factories will remain at the forefront of the expansion, according to the Institute for Supply Management. Purchasing managers anticipate sales will grow 5.5 percent next year and capital investment will increase 1.9 percent, the semiannual forecast from the Tempe, Arizona-based group showed on Dec. 6.
Labor Department figures on Dec. 8 showed weekly jobless claims fell to the lowest level since February. A day later, the Thomson Reuters/University of Michigan preliminary index of consumer sentiment rose to 67.7 for December, a six-month high, from 64.1 at the end of November.
Strategists forecasting falling yields are in the minority. The median estimates of 64 economists surveyed by Bloomberg is for 10-year rates to rise to 2.19 percent next quarter, 2.35 percent by the end of June, 2.5 percent in the third quarter and 2.6 percent a year from now.
Even if those estimates prove accurate, yields would still hold below their average of 3.19 percent in 2010, data compiled by Bloomberg show. That would help the administration of U.S. President Barack Obama finance a $1.3 trillion budget deficit. Interest expense on U.S. debt totaled 2.7 percent of gross domestic product in fiscal 2011 ended Sept. 30.
The economy is “not strong enough to generate a big move up in yields given the fear that’s out there,” said Roth at Mitsubishi UFJ.
Macroeconomic Advisers LLC cut its estimate on Dec. 2 for U.S. growth in the first half of 2012 to 1.9 percent, from 2.2 percent a month earlier, citing the negative “spillover” effects of the euro zone crisis.
“We have a financial and banking crisis in the euro zone,” Lawrence Meyer, a senior managing director in Washington at Macroeconomic Advisers and a former Fed governor, said in a telephone interview on Dec. 6. “The questions now are ‘Will it get worse?’ ‘How much worse?’ and ‘Will it get to a breaking point?’”
European bank demand for dollars remains about the highest since October 2008 even after central banks reduced the cost of emergency funds by half a percentage point on Nov. 30.
The three-month cross-currency basis swap, the rate banks pay to convert euro payments into dollars, was 122 basis points to 126 basis points below the euro interbank offered rate in London. That’s the most expensive since Dec. 5. The cost rose on Dec. 9 on concern the measures won’t stem the region’s debt crisis.
“The longer that Europe muddles, the more people will fear you’ll have some sort of disorderly breakdown,” Thomas Girard, a bond fund manager in a group with $115 billion in assets at New York Life Investment Management in New York, said in a Dec. 7 telephone interview.
The risks range from bank failures to a country leaving the euro currency, he said. “All of those things have the effect of putting downward pressure on Treasury yields.”
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