Time to sell treasuries

The benchmark 10-year treasury yield has traded sideways in a range from 2.5% to 3% since the taper tantrum of last summer. Now it is threatening to break out on the downside. If you expect a collapse in yields, you should load up on bonds and sell everything else. We don’t. The current bond rally has four likely sources: 1) Funds have been locking in equity gains and rebalancing into bonds.

2) The US deficit has narrowed dramatically, reducing new treasury supply. In recent years, the deficit was so large that the Treasury’s outstanding debt grew even faster than the Federal Reserve could buy it up. But over the last few months, the deficit has contracted so much that the net new supply of treasuries reaching the market has been close to zero, as the Fed has bought up almost all the new issuance. Lack of supply may have contributed to the recent rally (see chart overleaf).

3) A weak housing undermine US growth.

4) There is a flight out of peripheral eurozone bonds. With growth in southern Europe disappointing and the European Central Bank in a pickle, investors are fleeing peripheral eurozone bonds that no longer offer a good value proposition.

Let’s consider each of these in turn, before we get to the main reason why we would not buy into the rally.

1) We have been big proponents of balanced portfolios, split 50/50 between equities and 25 to 30-year treasuries. But as 30-year bonds have rallied (far more than 10-year bonds), we should now be taking profits and rebalancing into equities. While we would retain some 30year bonds, we would not touch 10-year treasury. Despite the

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to recent narrowing of the 30/10-year yield spread, it remains wide by historical standards, so the 30-year still offers better value than the 10-year bond.

2) If a contraction in new treasury supply has put upward pressure on prices this year, that engine is now reversing. Last year’s deficit reduction will not be matched this year. Meanwhile, the Fed is tapering with determination. In sum, the spigots of new treasury supply are reopening.

3) The housing sector has indeed appeared slow to pick itself up from the winter chill. The NFIB survey fell from 46 to 45 last week, when it was expected to rebound to 49. And although headline housing starts and permits jumped in April, this was largely due to a rise in the volatile multi-family sector (i.e. apartment buildings). Underlying growth in single family starts and permits also rose, but only modestly. Indeed, after mortgage rates and home prices rose last year, far outpacing income growth, there is no longer a strong valuation tailwind for housing. So we don’t expect the housing market to be a major engine of growth going forward—but neither do we expect it to be a big drag.

4) Capital flight from Europe’s periphery is the most likely driver of a sustained rally in treasuries. But this is a reason to maintain a balanced portfolio of equities and 30-year treasuries—not to pile into 10-year bonds.

But the main reason we don’t expect 10-year yields to break downwards is that it would be inconsistent even with a conservative structural outlook, as well as with the data flow on growth and inflation.

Historically, 10-year treasury yields have tended to track the structural nominal growth rate of the economy. Since they are free of any risk premium, they basically reflect expected real growth plus expected inflation. Assuming the Fed more or less hits its 2% inflation target over the next 10years, then at 2.5% today US treasuries are only pricing in 0.5% annual growth. That is too conservative, even for me. I may have argued that potential growth has fallen due to demographic changes, but it hasn’t fallen that far.

It is strange that treasury yields are threatening to break downwards at this time.While I don’t expect breakout growth or runaway inflation any time soon, recent data is picking up on the margin. Increasingly it appears that deflation is no longer looming.

On the contrary, April’s CPI bounced back to the Fed’s target of 2%. Core CPI was a bit lower, at 1.7%, but it is clearly on the rise, led by accelerating rents. Growth data has also been encouraging. The jury is still out on whether growth can break away from the roughly 2% rate that has become common over recent years. But it is clear that growth has at least bounced back from the frigid winter lull (the New York Fed’s regional Empire manufacturing survey jumped from 1.3 to 19 in May).

So, if you are long 10-year bonds, sell them. If you have followed our suggestion to hold a balanced portfolio of longer treasuries (25 to 30-year) and equities, then it is time to take some profits on the bonds and rebalance your portfolio.