Thursday, August 20, 2009

U.S. Treasuries: Asset Class Review

My recent asset class review focused on crude oil, gold, and the U.S. dollar. Now we take a look at U.S. Treasury yields.

Because Treasuries are insured by the U.S. government, they are considered a relative safe haven. Thus, in times of economic turmoil--such as we had in late 2008 and early 2009--we see active purchasing of Treasuries, which drives down their yields.

The two-year yields are sensitive to Federal Reserve policy--actual and anticipated; hence, they have stayed near 1% in response to continued Fed ease.

The ten-year yields (middle chart) and thirty-year yields (bottom chart) are sensitive to deflation, reflation, and inflation. They collapsed during the market turmoil--those safe yields were attractive to investors, leading them to snatch up longer-dated Treasuries--and now have bounced back significantly with easing of the crisis and reflation.

The result of the bounce in yields is a meaningfully steeper yield curve, which encourages lending by banks (who borrow cheap and lend dear). Indeed, the steepness (and steepening) of the curve has been a nice sentiment indicator for trader and investor perceptions of recovery. Fears of deflation (which drove the difference between thirty-year and two-year rates to around 2% during the height of the crisis) have abated; at the same time, longer-term yields are close to their mid-2008 levels and not pricing in unusual inflationary expectations.

Observe how yields bottomed in January ahead of stocks. We're also seeing an intermediate-term topping of yields, which have moved below their June peaks. I believe this is a possible lead signal of further anticipated weakness in the economy and topping in stocks. With the U.S. consumer still under the weather, disinflationary themes are every bit as much a concern as inflationary ones.