Friday, July 15, 2011

Treasury Yields Low for Good Reason

Great thoughts here by Tom Gallagher from Ezra Klein. Experts and pundits alike have been forecasting a spike in Japanese yields for over 20 years now. Japan's debt/GDP exceeds 200% yet yields on 10-year JGBs are barely above 1%. While enjoying dinner with some friends recently, I brought up Gallagher's third point that Treasury interest rates are a function of the expected rates over that time period. Bond investors therefore must consider the likelihood of inflation and the potential reaction by the Federal Reserve in regards to short-term interest rates.

From my perspective, continued private sector deleveraging will likely restrain economic growth and inflation for several more years. If federal government spending is reduced significantly during that time, deflation may become a real concern. Those conditions will likely force the Fed to maintain interest rates near 0% for a few more years before embarking upon measured hikes. While most investors are currently shunning Treasuries, current longer-term yields actually appear attractive. Contrarian investors may find that Treasuries currently possess superior relative value to stocks looking out 5 to 10 years.

From Ezra Klein at The Washington Post

Does Wall Street understand Washington better than Washington understands Washington?

Tom Gallagher is a principal at the Scowcroft Group, where he specializes in advising clients on monetary, fiscal and currency policies. In other words, when we talk about how Wall Street understands Washington, he’s one of the people serving as an interpreter. Here are his thoughts:

I feel like a recovering fiscal hawk, at least on the impact of deficits on interest rates. I used to spout all the reasons why the yield curve should be steeper because of the boomers, health care costs, etc., but after a while I felt as though I was giving 10 solid reasons why it should be raining outside, and then looking out the window and seeing nothing but sunshine. At some point you have to change your model.

Here are some thoughts defending the markets against what many Washington budget experts think markets should be doing.

First, any disruption caused by debt ceiling delays is very likely to be temporary, reversed by a relief rally when the debt ceiling is finally lifted. Savvy types on Wall St had to say to themselves when they read of McConnell’s proposal on Tuesday that they always knew Rs wouldn’t go through with it.

Second, deleveraging is the most important factor for rates right now. Numerous studies show that countries (not just Japan) that have experienced a financial crisis have low long rates coinciding with high budget deficits for some time. If the private sector isn’t borrowing much, there’s little to crowd out.

Third, many misunderstand what the 10yr yield is implying. It’s of course a function of the expected 1 year rate for each of the next 10 years. Right now the 10yr is around 2.9%, but that’s a function of how long the market expects short rates to be low, not a reflection of the impact of deficits on interest rates. When you look at forward rates (to be clear, not something drawn from an obscure, possibly illiquid market but rates derived from the yield curve), the expected 10yr yield 10 yrs from now is about 4.5%, or 160bp higher than current 10yr yields, which seems reasonable for likely real yields and inflation (if the Fed does its job). Is it reasonable from a deficit point of view?

That’s the last point, markets are giving policymakers a huge benefit of the doubt by assuming future deficits will be made sustainable. That’s a leap, but that’s what history tells you — the US has never let deficits run at a damaging level for a sustained period. Sure, there will likely be a time when yields rise in a way that compels Washington to cut deficits, but where exactly on the curve should that be priced in now?

My checklist for when the day of reckoning arrives is some combination of the following: deleveraging is close to running its course, emerging markets seriously revalue their currencies (taking EM central banks out as big buyers of treasuries), foreign govts clean up their fiscal problems (the PIMCO line about US treasuries being the least dirty shirt in the laundry), and Washington demonstrates an inability to cut longer-term deficits. The last isn’t the only item on the list.

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