Fed data shows commercial banks are buying securities again, seeking yield.
US jobs recovery signals strengthening economy
Is the US 10-year treasury bond fairly valued around 2.5 per cent or not? Is the second quarter growth rebound a blip and will 2015 be more like the first quarter of 2014? Are equity markets again missing a risk aversion warning sign that bonds are sending?
We’re of the view that the push lower in yields has changed from one where growth and risk aversion fears were the primary drivers to start the year, to one where the move is now being driven by technical factors.
The broader macro concerns that usually arise from a drop in benchmark yields (declining growth and deteriorating risk appetite) don’t appear to be supported by other measures within the fixed income market. Specifically, other growth barometers in the bond market, like corporate spreads and medium-term yields are signalling a stronger economy on the horizon, not a weaker one.
The US May employment report showed steady job growth. Nonfarm payrolls rose 217,000 and the unemployment rate held at 6.3 per cent. With the May report, the level of employment exceeded the prior peak, reached in January 2008. This milestone highlights the significant jobs recovery over the past several years; although, with population growth of 15 million since the prior peak, it’s clear significant slack remains. Excess capacity in the labour market explains why wages are still growing at the modest rate of 2.1 per cent year on year and justifies the US Federal Reserve’s prolonged accommodative policy stance.
The fact that long-term yields have led the fall in rates is reflective of mostly secular forces, rather than cyclical ones. There are several factors which can pinpoint to reasons for the Treasury resilience. For example, Fed’s large bond holdings, particularly at the back end, will suppress yields far into the future and are more important that the ongoing quantitative easing purchases.
Another one is pension funds that are underweight duration and overweight risky assets after last year’s equity gains. Inflation data remains soft and Fed data shows commercial banks are buying securities again, seeking yield.
From a relative basis, an important one is that US yields are also likely weighed down by European rates, specifically bunds (German equivalent of US Treasury bonds), which are low due to ongoing deleveraging in peripheral European economies and disinflationary risks, which are likely to persist there. Bunds have had an effect on where Treasuries trade, as in relative terms they have attractive yields. The subsequent move in the bund yields has put increasing pressure on the ECB to act, but some of the traditional Treasury investors have looked at global alternatives for yield.
The rally in long-dated yields may be partly a reflection of a falling “terminal fed funds rate” (the policy rate reached at the end of hiking), presumably in light of the unusually high level of labour market slack. As a result, we don’t find much value in Treasury bonds, when yields are at 2.5 per cent and the probability that tapering will be reversed is virtually zero.
Nevertheless, these secular forces make the bond market valuable to investors in a different way – they slow the normalisation process in bond yields, making other risk assets more attractive.
Cesar Perez is the chief investment strategist for Europe, the Middle East and Africa at JPMorgan Private Bank
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