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Last updated: May 12, 2014 10:54 pm
The big investing story this year is that the US “long” bond is back – and in a big way.
Not for the first time in a three-decade Treasury bull run, investors betting early that the US recovery and a gradual end to ultra-loose Federal Reserve policy would lead to rising 30-year Treasury yields have been made to look foolish.
Bond investors who bought short-dated Treasuries at the start of the year, while shunning the long bond, are trying to work out why the 30-year yield, which moves inversely to price, has dropped 50 basis points.
That slide has provided holders with a total return of 11 per cent since January, while short-dated debt has barely moved.
A combination of the Federal Reserve buying fewer 30-year bonds via quantitative easing and an accelerating economy was expected to push long-dated yields well above 4 per cent and deliver the last rites to a bull run that started in the 1980s.
Instead, the pronounced outperformance of long-dated bonds serves as a warning that the US economy’s very weak first quarter is about more than just a hard winter. That signal is being ignored by equity investors. They expect a rebound in the US economy will justify high stock prices and push Treasury yields higher.
As it stands, the 30-year yield has edged up 14 bps from this month’s low of 3.35 per cent. So is 2014’s double-digit rally a last hurrah?
Certainly, a further drop in yields requires much weaker US economic data, lower inflation and intensifying global macro and geopolitical concerns in China and Ukraine.
“The bond market is trading on the view that we are not going to see a strong rebound in the economy during the second quarter,” says Richard Gilhooly, strategist at TD Securities. “We need to see sustained weakness in the economy to justify low bond yields.”
At its current yield, the 30-year bond suggests the Fed will only raise its overnight borrowing rate to about 2.75 per cent rather than the long run level of 4 per cent predicted by policy makers, says Gene Tannuzzo, money manager at Columbia Management, a scenario he thinks is too low as the economy is gaining speed.
But the bond market may take some convincing as not even a solid April jobs report earlier this month derailed the Treasury rally. The message from low long-term bond yields is that an economic rebound will prove fleeting and is not a precursor to sustained growth above 3 per cent and accelerating inflation, therefore limiting the scale of future Fed rate hikes.
Support for the bond also comes from global deflationary concerns and more money chasing fewer high quality assets around the world.
Jay Mueller, senior portfolio manager at Wells Capital Management, says: “We may be in a brave new world where the US economy does not grow faster than its historical real rate of 3 per cent, and due to demographic changes and globalisation, we continue to see strong demand for long-dated bonds.”
At last week’s $16bn sale of new paper, institutional investors accounted for 40 per cent of the supply, in line with their recent demand, in spite of 30-year yields sitting at their lowest level in nearly a year.
The story, say traders, reflects a variety of forces: pension plans and insurers selling equities and locking in their long-term liabilities via bonds, to formerly bearish investors now having to buy bonds and adjust their portfolios.
For many managers, who track a bond index, the outsized gains for 30-year bonds means that underweighting interest rate risk has resulted in a lagging performance.
Mr Tannuzzo says the bond rally has caught people off guard and illustrates why investors should have exposure to long-term rates in their portfolio.
While the bears may bide their time and wait out the expected rise in bond yields as the Fed completes its taper, upward pressure may be less robust than they picture.
Ian Lyngen, strategist at CRT Capital, says: “When you remove the Fed as the largest buyer of long-dated Treasuries, it means more 30-year bonds will enter the index. That reintroduces a natural buyer into the market via investors whose portfolios are linked to an index.”
As it stands, it is not just pension funds and insurers buying, with the iShares 20+ year Treasury bond exchange traded fund registering $280m of inflows since January, after a $430m outflow during 2013.
“Money has come back into the market this year,” says Mr Tannuzzo. “If you look across G10 countries, you can see that the US [in yield terms] is attractive relative to Germany, Japan and core Europe.”
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