Treasury Bond Rally Could Point to Trouble Ahead

Bramshill News

By Amey Stone

June 11, 2016

Treasuries rallied last week, but celebrations aren’t in order. Sure, bonds get more valuable when interest rates fall, but it is disconcerting when yields get this low.

Treasury rates have now fallen below the lows of mid-February—when oil was crashing and global markets feared recession. The yield on the 10-year note closed Friday at 1.64%, nearly a four-year low, according to Tradeweb. The yield curve flattened, with the spread between two-year and 10-year notes at a nine-year low.

For Treasury rates to be so low suggests economic weakening and fragile markets. Pixabay

Already low European and Japanese rates plumbed new depths. The 10-year German Bund threatened to turn negative, ending the week with a yield of just 0.02%. Fitch Ratings estimated that at the end of May, $10.4 trillion in sovereign debt was trading with negative yields, up 5% from April. That number is even higher now.

For rates to be so low—and the yield curve so flat—suggests economic weakening and fragile markets. “The world, including the U.S., is coming around to the view that potential growth is lower,” sums up Raman Srivastava, portfolio manager of the Dreyfus/Standish Global Fixed Income fund. “That keeps a lid on yields.”

But there are reasons for the lower Treasury yields that have little to do with the U.S. economy, which is actually growing faster in the second quarter than it did in the first. Huge global demand for U.S. bonds, which yield much more than bonds of other developed countries, is a big part of the story. Recent Treasury auctions indicate demand from foreign buyers is at record levels. The European Central Bank started buying member-country corporate bonds last week, helping to drive down corporate rates in the U.S. as well.

The British vote over exiting the European Union, known as Brexit, is June 23. Polls suggest a close vote. That’s creating demand for safe U.S. bonds since global markets are likely to freak out if the U.K. votes to leave. Political risk in general is running high, including in the U.S., says Srivastava. Meanwhile, economic data has disappointed despite epic amounts of stimulus, calling into question central banks’ effectiveness.

And let’s not forget the Federal Reserve, which meets Tuesday and Wednesday this week. The Fed won’t hike rates given the jarringly weak May payrolls report, but it may still raise them later this year. Investors who believe that would be a policy mistake may be buying Treasuries as a defensive move against more market mayhem.

Focus on Funds

“The message is a bit clouded,” says Anthony Valeri, a strategist at LPL Financial. He thinks events in Europe are the main driver of the recent Treasury rally and that it could reverse. Still, he says, “if the yield holds below the 1.66% level for a number of days, that’s a very strong statement that lower yields may be here to stay for longer.”

FOR INCOME INVESTORS , the best advice is to diversify across different types of assets, says Jim Sarni, managing principal of investment firm Payden & Rygel. “You need a wider opportunity set,” he says.

Jenny Van Leeuwen Harrington, portfolio manager at Gilman Hill Asset Management, argues this environment favors dividend stocks. Not only do many yield more than bonds, but some, such as utilities, benefit from low interest rates. Art DeGaetano of Bramshill Investments believes corporate credit is the best place to find yield with less risk. He notes his fund is positioned conservatively ahead of Brexit.

Srivastava holds sovereign bonds from countries like Australia and New Zealand, where central banks may be pressured to cut rates now that the U.S. is less likely to hike rates soon. Sticking with high quality, despite low yields, makes sense, he says. Riskier assets are generally supported by lower rates, but with yields low and stock prices high, markets are vulnerable to a shock, and the stimulative power of monetary policy is limited, Srivastava says, adding: “That’s a troubling prospect.”