Thanks for the rally, European Central Bank.

Photographer: Martin Leissl/Bloomberg

Rally Round U.S. Treasuries

A. Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” Some portfolios he manages invest in currencies and commodities.
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The U.S. Federal Reserve sounded an “all clear” for Treasury securities at its March 18 meeting. With continued problems in the U.S. labor market, stagnant real wage growth, flagging retail sales and deflation worries, the Fed won't be raising rates anytime soon. Treasury prices, then, are sure to rise. 

The coming rally will draw strength from steps that central banks in Europe and Japan are taking to boost exports by devaluing their currencies, which drives investors to the U.S. What's more, government-bond prices, even for Spanish and Italian debt, are higher than in the U.S. It won't be long before investors narrow those gaps by purchasing Treasuries.

The Fed started the springtime rally last week when it effectively signaled it wouldn't soon increase interest rates by cranking down forecasts for the federal funds rate and inflation. The economy, the Fed said, is now “moderating” instead of “expanding at a solid pace.” 

The central bank also cut its 2015 economic growth outlook to 2.5 percent from 3.4 percent, much like the repeated downgrades of its gross domestic product forecasts for 2012, 2013 and 2014. 

The Fed's post-meeting release dropped the statement that the Fed would be “patient” before raising interest rates. To make sure no one thought that meant an imminent rate increase, Chair Janet Yellen said: “Just because we have removed the word ‘patient’ from the statement doesn’t mean we’re going to be impatient.” 

The Fed’s dual mandate is to promote full employment and price stability. It hasn't accomplished either. Payroll employment has accelerated, with almost 282,000 new jobs a month in the last 11 months, significantly higher than the average of about 185,000 between October 2010 and March 2014. 

But most of the new jobs are in low-paying sectors such as retailing and hospitality, not high-paying fields such as manufacturing, utilities and information technology. Also, with corporate revenue growing slower in this business expansion versus other recoveries, the route to larger profits has been through cost-cutting. Most costs, directly or indirectly, are for labor. 

Real wages and median household incomes, as a result, have been flat, which slows down consumer spending. Households are putting away rather than spending the savings from the recent drop in gasoline prices. Retail sales fell in December, January and February, while the household savings rate jumped. 

The Fed defines its second mandate, price stability, as 2 percent inflation. Many other central banks use the 2 percent inflation target as well. They don’t love inflation, but they fear the deflation that has plagued Japan for two decades. As prices fall, potential buyers anticipate further declines by putting off purchases. Excess capacity and inventories mount and depress prices further. That confirms consumers' suspicions, so they further cut spending, to the detriment of economic growth. 

After the Fed’s March 18 announcement, Treasury bond prices leaped. I continue to believe that the 30-year Treasury yield, now 2.59 percent, will drop to 2 percent in a year, for a total return of about 15 percent. For a 30-year zero-coupon bond, I expect about an 18 percent return. I also look for the 10-year Treasury yield to drop from the current 2 percent to 1 percent, producing a total return of about 10 percent. 

With the odds falling for a Fed rate increase in the near future, investors are beginning to concentrate on the shrinking issuance of Treasury notes and bonds, which fell to $693 billion in February from $1.7 trillion in the 12 months ending May 2010, as the fiscal 2014 federal deficit declined to $483 billion from $1.4 trillion in fiscal 2009. On the demand side, foreigners continue to charge into Treasuries as the ultimate safe haven in a sea of global economic and financial trouble. Their holdings have jumped by almost $232 billion from January 2014.

 And there’s plenty of money available to buy Treasuries, with quantitative easing taking place in Japan and the euro zone. The Bank of Japan is buying up to $100 billion in securities a month, while the European Central Bank recently began purchasing $65 billion a month. As those central banks deliberately drive down their currencies, they encourage investors to flock to Treasuries.

There is another compelling argument for substantial rallies in Treasuries: The gaps between their yields and those of most developed countries are astoundingly wide. The 2.087-percentage-point difference between the 10-year Treasury note yielding 2.005 percent and the -0.082 percent yield on a 10-year Swiss government obligation seems excessive in today’s world. So does the 1.8-percentage-point difference between 10-year Treasuries and 10-year German bunds yielding 0.21 percent.

Just as amazing is the lower yield on 10-year Spanish sovereigns (1.256 percent as of March 26) compared with the 2.005 percent yield on the 10-year Treasury. The same goes for the 69-point gap between U.S. and Italian 10-year bonds. 

Those gaps are ridiculous -- unless you believe Spain and Italy issue higher-quality government obligations than the U.S.! Only Australia, among 17 developed foreign countries, has a higher 10-year bond yield than does the U.S., by 0.32 percentage point. 

These yield gaps scream to be closed, and no doubt will be, by a rally in Treasury prices. With the Bank of Japan and the ECB buying up sovereigns, yields in those regions will probably fall further. 

Investors in the euro zone and Japan can get better returns by buying Treasuries as opposed to their own sovereigns. They will get better capital appreciation as Treasuries rally. And they profit further as the dollar continues to rise against the yen, euro and almost every currency. What am I missing?

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
A Gary Shilling at insight@agaryshilling.com

To contact the editor on this story:
Paula Dwyer at pdwyer11@bloomberg.net