“The Federal Reserve has been aggressive in its efforts to stabilize our financial system and to support economic activity. At some point, however, we will need to unwind our accommodative policies in order to avoid higher inflation in the future” Bernanke 12/06/2009.
I came back to work to find the quote above in the latest presentation of our Chief Investment Officer, Steen Jakobsen, and I immediately feel the irony. The policies implemented by the Federal Reserve since the global financial crisis until today seem not to have put a definitive solution to the financial market’s problems. Actually, it created a new issue: the market likes the FED’s money too much! So much that right now, it depends on it.
We can stay here talking all day about balance sheet normalization; however, if we look at the practice, we will see that a FED’s balance sheet runoff was not feasible a year ago, it isn’t now, and it might never be! Indeed, it was just a few months after the FED started to wind down its balance sheet in 2018 that the market got into liquidity troubles. Therefore, the central bank was forced to make a U-turn on its normalization plans to support the market again.
And then, coronavirus arrived.
Investors’ fear combined with the FED’s stimulus expansion pushed US Treasury yields to the lowest levels seen in history.
At this point, investors might ask, does it make sense to buy Treasuries at near-zero yields?
The answer’s easy: it all depends on inflation.
(1) Yes, it does make sense to enter in US Treasuries at current yield levels.
US Treasuries advocates agree with the idea that we will see deflationary pressures, rather than inflationary, in the aftermath of a coronavirus pandemic. At that point, the only option for the FED is to be more aggressive and to continue to stimulate the economy.
There is plenty of signs that investors believing in lower or negative Treasury yields might be right. For example, even though “positive news” is driving the equity market higher at the moment, in the fixed income market, there are signs that investors are on edge. In the graph below, you can see that demand for the US 10 year swap remains robust although it’s trading in the middle of a tight range since the volatility of March/April. A rise in Treasury Swap spreads signals risk aversion, which translates into higher demand for safe heaven securities, thus ultimately lower US Treasury yields.
Not only the market continues to be nervous, but there might be some bad news lagging. As you can see from the graph below, during the global financial crisis, loan delinquencies rose at the same pace as the unemployment rate. Yet, in the wake of the coronavirus pandemic, loan delinquencies have not been rising as fast as unemployment. One can argue that the FED’s response to the coronavirus was enough to limit shocks in the system. However, there is a probability that loan delinquencies are lagging. If that is the case, as loan delinquencies rise, investors will fly to safety pushing US rates further down.
Looking at European sovereigns, one can argue that there are plenty of negative interest rates. Thus, given the number of uncertainties in the market, it is just a matter of time before Treasury yields also turn negative.
However, what if inflation spikes out of control?
(2) No, it doesn’t make sense to enter in US Treasuries at current yield levels.
Overshooting inflation is a possibility that we believe needs to be seriously taken into account. As Steen Jakobsen has recently explained, what is different today from the 2009 FED’s stimulus is that, now, the only role of the central bank is to finance the fiscal deficit. This puts upward pressure on inflation together with other tools that are already in place to trigger it, amplifying its effect.
In case of inflation rising fast, locking your money in Treasuries with near-zero yields would be atrocious as inflation would eat up returns and savings fast.
There is an interesting point I would like to highlight. If inflation spikes out of control, one would think that the only course of action for the FED would be to hike interest rates. Nevertheless, the graph below shows that the Fed might not even be able to hike interest rates at all! As a matter of fact, while US Treasury yields have been falling since the ’80s until today, the cost of servicing the federal government’s debt has been rising because of the greater volume of debt securities that the government has been issuing and accumulating over the years. To put it simply, the US Treasury cannot afford higher interest rates!
To finish, I believe that it is vital for investors to consider their investment horizon and objectives before entering in Treasuries at such low yields. In the short term period, it could make sense to hold on Treasuries while inflation remains subdued, but for longer-term investments, diversification into inflation protection securities will prove to be crucial.