The Inevitable Selloff in Treasuries Is Greatly Exaggerated

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And it isn’t just global shocks that may support Treasuries. While jobs are back and business confidence is growing, wages remain stagnant.

And it isn’t just global shocks that may support Treasuries. While jobs are back and business confidence is growing, wages remain stagnant.

Photographer: Luke Sharrett/Bloomberg

Don’t count out Treasuries just yet.

Even after the prospect of higher U.S. interest rates sparked the deepest selloff in two years, Prudential Financial Inc., RBC Global Asset Management and ED&F Man Capital Markets say there are still plenty of reasons to keep government bonds in demand.

From worries over Greece’s financial ruin to the sudden collapse of China’s stock market, events halfway around the world are prompting traders to question whether the Federal Reserve will start raising borrowing costs before year-end. Deutsche Bank AG, one of the 22 primary dealers that trade directly with the Fed, now expects the central bank to hold off until 2016.

And it isn’t just global shocks that may support Treasuries. While jobs are back and business confidence is growing, wages remain stagnant. That suggests the weakest expansion in the post-World War II era is still struggling to generate the kind of inflation that causes investors to abandon U.S. bonds. What’s more, the last time that 10-year notes were so cheap relative to short-term debt -- in September -- they rallied during the next three months.

“There’s a good chance yields are going to crest here,” Robert Tipp, chief investment strategist in Prudential Financial’s fixed-income unit, which oversees $560 billion, said from Newark, New Jersey.

Tantrum Redux

Since reaching a peak of 2.5 percent in June, yields on 10-year Treasuries have retreated and ended at 2.38 percent on Thursday. U.S. financial markets were closed on July 3 to celebrate the Fourth of July holiday.

The yield was at 2.3 percent as of 8:55 a.m. in New York.

Signs of renewed demand come after Treasuries tumbled 2 percent last quarter, index data compiled by Bloomberg show.

The slump was the biggest since the three months ended June 2013, after then-Fed Chairman Ben S. Bernanke sparked the “taper tantrum” by suggesting the central bank may end its bond-buying program.

The selloff, part of a global rout in bonds, gained momentum in the past month as reports on labor growth to personal spending indicated the U.S. economy was on an upswing, strengthening the Fed’s case for finally raising rates after leaving them close to zero since 2008.

Tipp says that’s made longer-term Treasuries more attractive. Based on a metric known as the “term premium,” 10-year Treasuries offer 0.5 percentage points more in yield than short-term debt. The last time that happened, the notes returned 3.6 percent in the next three months in the biggest quarterly advance since 2012.

Capital Flight

Global events are also putting a premium on safety and delaying the exodus from Treasuries that almost everyone on Wall Street predicted would be inevitable.

In Europe, the crisis in Greece escalated the nation missed a $1.7 billion payment to the International Monetary Fund and voters rejected further austerity measures demanded by creditors, heightening concern a financial collapse may fracture the euro bloc and spark capital flight from the region.

Investors will start to focus on “what’s the next Greece,” Brandon Swensen, the co-head of U.S. fixed income at RBC Global Asset, which oversees $35 billion, said from Minneapolis. “Any event that catches the market off-guard, it’s very predictable that Treasuries are going to rally.”

China Bubble

The bursting of China’s stock bubble is also deepening concern about the health of emerging markets, after investors there lost more than $3 trillion in three weeks.

While America remains the bright spot, the potential knock-on effects of higher U.S. rates on the global economy have already prompted both the World Bank and the IMF to call on the Fed to delay any increases until 2016.

Traders are signaling the Fed will heed their advice. Based on Morgan Stanley’s analysis of futures trading, the first rate increase won’t occur until January. In March, the market was anticipating a September rate rise.

“Given all the uncertainty, this makes it harder for investors to feel confident” about the economy, said Gary Pollack, who manages $12 billion as head of fixed-income trading at Deutsche Bank AG’s private wealth unit in New York. “The safest place to be in these uncertain times is the safety of Treasuries.”

Uneven Footing

The latest labor reports indicate that even in the U.S., the economy remains on uneven footing, giving the Fed room to stay patient. Although employers hired more workers in June, average hourly wages were unchanged at $24.95 an hour from the prior month, a Labor Department report showed July 2.

And the lack of wage pressure is one reason why inflation remains almost non-existent.

Annual consumer prices have fallen or remained flat every month this year, and bond traders expect inflation will stay well below the Fed’s own 2 percent target through the end of the decade, data compiled by Bloomberg show.

“The two things that matter most as far as the timing of liftoff is concerned are wage growth and inflation, and right now we don’t have either,” said Ward McCarthy, chief financial economist at Jefferies Group LLC in New York.

The risk, of course, is that investors in Treasuries underestimate the willingness of Fed officials to raise borrowing costs as they anticipate a strengthening economy and faster inflation. On June 30, Fed Bank of St. Louis President James Bullard said while Greece’s potential meltdown would spur demand for Treasuries, it’s unlikely to sway policy makers.

Complacency Risk

“It would not change the timing of any rate hike,” he said. “I would say September is very much still in play.”

In June, Fed officials maintained their year-end forecast for its benchmark rate at 0.625 percent, which implies two quarter-point increases by December.

With inflation so low, the Fed’s fixation on raising rates from rock-bottom levels may actually squelch growth and prematurely cut short any upswing. That may ultimately boost demand for Treasuries, according to Prudential’s Tipp.

“I don’t think they can be that myopic and say they can tighten with all that’s going on,” Thomas di Galoma, the head of fixed-income rates and credit at ED&F Man, said from New York. “We’ve seen the highs for the year” in yields.

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