Time to sell trea­suries

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

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




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.

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