SERIOUS MONEY:Investors in US Treasury bonds have suffered material losses since the start of the year, writes CHARLIE FELL
IT HAS been a difficult start to the year for investors in US Treasury bonds. The benchmark 10-year Treasury yield began the year at 2¼ per cent and, though yields jumped to 3 per cent by early-March, the market rallied furiously following the Federal Reserve’s announcement that it intended to purchase Treasury notes and bonds for the first time since the infamous Operation Twist was abandoned in 1965.
Ten-year Treasury yields registered the sharpest drop since the crash of 1987 upon the announcement. But bond prices have been in free-fall ever since, as yields have jumped by 120 basis points (1.2 percentage points) to 3.7 per cent.
The bear market in treasuries has been accompanied by commentary questioning the sustainability of America’s “AAA” credit rating. Some have even suggested that hyperinflation is a distinct possibility. But perhaps there are less dramatic explanations that help to explain the significant back-up in yields.
There is no doubt that America’s deteriorating fiscal position is a matter of concern. The Congressional Budget Office’s most recent projections for the budget and economic outlook indicate that outstanding debt is set to rise from 41 per cent of GDP last year to 57 per cent this year and then to 82 per cent by 2019.
This is certainly a dramatic increase in the debt load, but when the ratio of government debt to GDP jumped markedly in the US during the 1930s and 1940s, and in Japan since the 1990s, yields continued to decline. Thus the notion that the back-up in yields is as a result of reduced creditworthiness doesn’t really have much merit.
It has also been argued that yields have jumped higher due to the reluctance of creditor nations to accommodate the substantial jump in net new issuance in the current fiscal year. However, this argument ignores the fact that the US in aggregate is borrowing less from abroad today than at any time in several years.
It is true that the government is borrowing more, but the external financing requirements of US households and businesses dropped precipitously last year. Government borrowings have increased sharply, but the rise in US savings means that America’s external financing requirement is falling.
The idea that the bond market sell-off reflects increasing inflation angst doesn’t carry much weight either.
The Federal Reserve’s aggressive expansion of its balance sheet does not create any inflationary pressures if, as is the case today, the additional liquidity merely sits as excess reserves in the banking system.
Furthermore, the substantial under-utilisation of both capacity and labour suggests that problematic inflation is a distant threat.
Finally, long-term inflation expectations, as reflected in the prices of Treasury inflation-protected securities, remain well-contained below 2 per cent.
It would appear that the back-up in yields reflects primarily a return to normalcy as investors have priced out an impending economic and financial collapse.
However, the recent turbulence in the bond market cannot be fully appreciated without an understanding of the US home mortgage market, which has undergone dramatic change since the 1980s. The value of outstanding residential mortgage debt has grown almost tenfold over the past 25 years. A substantial increase in financial disintermediation has seen the percentage of mortgages in the hands of traditional depository institutions drop to less than a third today. Roughly 60 per cent of the outstanding stock are repackaged in portfolios and sold to investors, of which the overwhelming majority are fixed-rate.
A fixed-rate mortgage loan has peculiarities that differentiate it from a typical default-free government instrument. US homeowners have the right to pre-pay their fixed-rate mortgages at any time without penalty. Consequently, investors are exposed to prepayment risk.
When long-term interest rates fall, prepayments typically increase and investors receive capital sooner than expected, which is then invested at lower market rates. Conversely, when the yield on long bonds moves higher, prepayments slow just at the time that investors desire more capital to reinvest at higher market rates.
The bottom line is that the price of fixed-rate mortgage instruments declines by more than treasuries of similar maturity when long-term interest rates rise and increase by less when yields fall.
It should come as no surprise that investors in the mortgage market attempt to hedge prepayment risk, but such activity can and does aggravate movements in the bond market. Lower long-term interest rates lower duration or the average life of mortgage investments. To increase duration and provide a hedge against further decreases in yields, investors will reduce short positions and purchase long-term Treasury bonds, but if expectations reverse as recently mark-to-market accounting and the risk of capital loss ensures that the required reduction in duration will happen quickly through an increase in short positions and the sale of treasuries. Research by the Federal Reserve confirms that the actions of mortgage investors accentuate movements in yields particularly in rising rate environments, but notes that the impact is short-lived.
Investors in US Treasury bonds have suffered material losses since the start of the year, causing some to proclaim that the seeds of hyperinflation are being sown. Careful analysis, however, suggests that the reasons behind the big bond market sell-off may not be so dramatic after all.
charliefell@sequoia.ie
