Economic Analysis: Why Treasuries are Now a Good Trade

The Federal Reserve (Fed) will begin to tighten policy at some point in the second quarter of 2015. As this date inches closer, then the prices on U.S. Treasuries will fall. This means interest rates will rise. However, there is a contrarian view that prices move higher.

The journey for the fourth quarter will be about a risk off. This means Treasuries with a long expiration date, with their proxies should perform the best. What are their proxies? These are investment grade bonds. Why will this happen? Investors are looking, or will be looking for safe havens as they look for the Fed to tighten policy and China’s slowing economy.

The Fed will end the quantitative easing program (QE) on October 30. Questions, about the hike in rates, will then become more urgent. Investors will start wondering how high rates will be hiked. The Fed needs, must be, very transparent here. They need to pin down expectations. Still, we need to prepare ourselves for impending market volatility as the Fed can only do so much and history has shown they never quite get that reversal in policy course quite right.

We are beginning to change our expectations for China’s economic growth. There is uncertainty emerging and this will also lend support for Treasuries. This comes in the wake of China’s Finance Minister Low Jiwei making comments that their 7.5 percent growth target is not attainable. This raises fear they will fall under that number.

We might have already seen this trend emerging in September. Treasuries eked out a positive return for the third quarter. The benchmark 10 year Treasury rose from 1.60 percent from May when the Fed began to talk about tapering its massive bond buying program. However, despite expectations to climb above three percent, we are oscillating around 2.3570 percent. We saw a one year low last week.

We expect yields, which have an inverse relationship to price, to remain depressed.

This will continue as German Bund yields remain low. The spread between the 10 year Bund to 10 year Treasury bond is pretty wide right now. This means there is not a lot room for 10 year Treasury yields to shoot higher. Especially if the Bund rates remain flat or fall even more.

There is a distinct possibility that Bund yields will continue to fall. Why? Market rates continue to dip and inflation, the chance of seeing rising inflation, are becoming slimmer. Optimism over the European Central Bank’s (ECB) easing is beginning to wane. They did not do enough and investors are not happy.

The European recovery story is done. It has been ripped to shreds. We are seeing problems spread throughout the common currency bloc and that is now the dominant economic story. German industrial data, from this past Tuesday, came in very weak. This will have a negative impact on growth in Europe’s powerhouse economy.

Bottom line, we are expecting the next big move out of the Federal Reserve to be that rate hike. How much is now the question. The market is very worried but disinflation if not deflation out of Europe. This means we could see Treasury yields fall.