Treasury Rates In 2012

Loan the United States $100,000 by buying a five year Treasury and you will receive $800 per year subject to federal taxation. In early December, the interest rate on the five year Treasury bond fell to 0.80%. This fall, rates on five year Treasury bonds have dropped to an all-time low in United States history. The ten year Treasury is l.92% at this writing.

As Randall Forsyth noted in the December 17, 2011, Barron’s (Dow Jones weekly newspaper), “Treasury yields [have] plunged to previously inconceivable low levels…. The declines to those incredibly low yields also came as the U.S. lost its triple-A rating.” It is important for the prudent macro-economic investor to get a handle on what for many are “inconceivable” and “incredibly low” rates. This article will discuss why these rates have fallen so low and where they are likely headed in the year ahead.

Why So Low?

A year ago, the consensus of blue chip economists polled by the Wall Street Journal predicted that rates on U.S. Treasuries would rise in 2011. The opposite has taken place. The five year stood at 2.02% on January 3, climbed to 2.40% in February and then fell to .80% in early December.

A number of complex inter-related factors contributed to the decline in treasury rates:

• Flight to safety by institutional and individual investors in the United States and around the world. Within the United States investors have parked large amounts of funds in government securities fearing declines in stocks and shaken by the volatility of the stock market. International investors have pulled money out of sovereign debt in Europe, fearing default or declining bond prices as rates there rise. A significant portion of those funds are being invested in United States Treasuries. “People don’t feel comfortable being anywhere but in Treasuries,” says Paul Horrmann, of Tradition Asiel Securities Inc. “There are few places to park money that are safe. Supply doesn’t matter. Treasuries are benefiting from an enormous flight to quality,” explains Jack Kelley of Standard Life. Investors are selling Euros and buying dollars in the form of Treasuries, notwithstanding the lower yield on U.S. sovereign debt, to avoid the risk of a depreciating Euro. Most Americans fail to appreciate that the dollar is the world’s principal reserve currency and not merely a national currency and medium of exchange. Central banks keep 60 percent of their foreign-exchange holdings in dollars.

• U.S. Treasuries are also attractive because of their ready liquidity in highly volatile markets.

• Money market accounts are even lower yielding. On December 15, the average seven-day compounded yield for money market accounts was flat at 0.02 percent, as was the 30-day compounded yield at 0.02 percent. Morningstar’s December report on exchange traded funds (ETF) flow for 2011 revealed, “For the year to date, the taxable-bond asset class has raked in $37 billion. By that metric, the taxable-bond asset class has claimed the single-largest asset-class-level inflow.” Add to this, the Federal Reserve’s stated intention to keep the Federal Funds rate at essentially zero until mid-2013, and “Operation Twist,” where the Fed has shifted purchases from short term Treasury bills to longer term Treasury bonds.

• U.S. Treasuries are the bedrock of the international debt market. The vast increase in the world’s money supply by the major central banks (e.g., Federal Reserve, Bank of England) to counteract the recession and bursting of the financial bubble, inevitably leads to asset inflation. When investors first and foremost seek safety, the asset class of choice is government bonds.

• Finally, there is the sheer momentum from the favorable trade. Purchasers of U.S. Treasuries have increased their exposure as the price of these bonds has soared, especially when compared to stocks. PIMCO, the world’s largest bond fund, after mistakenly dumping Treasuries at the start of the year has ramped up their purchases in recent months.

At the start of 2011, the broad consensus was that the yields on Treasuries would rise. Despite a U.S. credit downgrade, a budget deficit running at nearly 10 percent of output (GDP), and higher yields available in Europe, Treasury rates fell over the year. As the discussion above demonstrates, simplified conclusions often backfire in an increasingly complex world financial system.

The Year Ahead: Up, Down or Sideways?

Most eminent forecasters are predicting Treasury rates will rise during 2012. The prudent investor will keep in mind the factors that drove rates down this past year when assessing decisions going forward. The biggest factor may again be Europe. Bill Gross, the head of PIMCO, predicts that over the next two years the euro and dollar will reach parity. To achieve parity large quantities of euros would need to be sold off and dollars purchased in the form of Treasury bonds and bills. The net result would be even lower rates and higher prices for Treasuries.

David Calloway, editor in chief of CBS Marketwatch, recently observed, “Whether Europe’s leaders save the single currency for another year – or two, or three – is important to large banks and global markets. But the idea of the euro’s emergence from the crisis as a strong [alternative] reserve currency is now indefensibly out the window.”

On another front, Congressional deadlock and uncertainty over the Presidential election may result in market instability and continued retreat into the safety of Treasuries, which would drive rates down.

But a number of factors suggest that Treasury yields will rise in 2012. For example, the consensus of Blue Chip economists is that the Gross Domestic Product growth rate will pick up in the coming year, thereby enhancing corporate profits and confidence. Key components of the domestic economy such as home construction and auto production appear to have bottomed out. The extremely low rates for Treasuries and money markets are increasingly driving investors to higher yielding alternatives, which would tend to drive up Treasury yields in tandem.

Putting it all together, there is massive uncertainty. A recent Associated Press article sums up the situation:

It's forecasting time on Wall Street, and once again the pros are trying to predict the unpredictable. As Yogi Berra said, “It's tough to make predictions, especially about the future.” In typical times, guessing where stocks will end up in a year is difficult. There are many assumptions about economic growth, inflation and consumer spending that go into the calculation. Now, forecasting has become nearly impossible. Big unknowns hang over the market as rarely before. Will the euro break up? Will China slow too sharply? Will squabbling in Washington scuttle the economic recovery?

At the same time, it is clear that Treasury rates do not have much more room to fall. While some noted pessimists have predicted a ten year rate near l.50% and five year near .50%, these would amount to relatively small declines from current levels. The slide in Treasury rates began in 1981. As this column has described repeatedly, this long mega-cycle is at or very close to its end. The Fed Funds rate has already bottomed out at essentially zero. Looking ahead to the next decade, the prudent macro investor must readjust her thinking to this critical change.

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