Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Head of Fixed Income Strategy
Summary: During the 2011 U.S. debt ceiling crisis, long-term U.S. Treasuries rallied. While the same can happen today, it's critical to realize that most of the gains in long-term U.S. Treasuries materialized after President Obama and House Speaker John Boehner agreed to increase the debt limit. Those elements that contributed to intensifying the U.S. Treasury rally might not exist today. As U.S. Treasury yields continue to trade rangebound and T-bills remain one of the safest instruments available to investors, we prefer to keep duration at a minimum and take advantage of the front part of the yield curve.
Today, I want to add more context to the piece I published last week concerning the debt ceiling and T-Bills.
The debt ceiling crisis is not new. If you go back to the Summer of 2011, you will find that the U.S. was days away from default and that negotiations between President Obama and House Speaker John Boehner were not going anywhere.
Two days before the supposed X date, the parties agreed to reduce the deficit and increase the debt ceiling, thus avoiding default. Following this agreement, the debt ceiling was allowed to increase by $1.5 trillion, and on August 3rd, the national debt increased by about 60% of the new debt ceiling, the largest one-day increase in the country’s history. Consequently, the U.S. became one of the most indebted countries in history, together with Greece, Italy, Lebanon, and Iceland, as its debt-to-GDP ratio rose above 100%. A selloff in markets ensued, and on August 5th, Standard & Poor's credit rating agency downgraded the long-term rating of the United States.
Contrary to what many believed then, longer-term U.S. treasury bonds gained, especially the safe havens with 10-year yields dropping more than 70 basis points in just ten days.
Therefore, the case to hold long-term U.S. Treasuries amid a debt ceiling crisis is compelling. However, it's essential to consider the followings:
Looking at the graph above, from the beginning of July 2011 until August 10th, 10-year U.S. Treasury yields dropped by more than 100bps. Yet most of the drop (70bps) occurred after an agreement was reached to increase the debt ceiling on July 31st. Why? Because (1) markets were reassured that the U.S. would be able to pay its bills, (2) a selloff in stock markets was triggered by the largest one-day national debt increase in history together with agreed spending cuts, and (3) S&P’s downgraded the U.S. long term credit rating, increasing safe havens appeal. Thus, in July 2011, amid the debt ceiling debacle, 10-year yields dropped by 35 bps only. Subsequent events caused the most significant gains.
This consideration leads us to one big question: can the same also happen this time? Maybe, but it depends on the stock market. With a debt ratio of 136%, the U.S. is already one of the most indebted countries in the world. Rating agencies might proceed to downgrade the country’s rating further; however, if there are no substantial spending cuts, it might be challenging to see a 4% drop in NASDAQ or S&P. Let’s not forget that the stock market is on steroids and that a drop in long-term U.S. Treasury yields (regardless of the cause) can be seen as positive for tech stocks. Therefore, there is a significant probability that long-term U.S. Treasuries will gain, but probably less than we witnessed in 2011.
Compared to T-Bill, long-dated U.S. Treasuries carry a much higher duration risk. If yields rise, you will lose much more value on your investment than short-dated bonds.
Ten-year US Treasuries yields are trading in the lower part of the range they have been trading since March. That means that if inflation remains sticky and the economy continues to show bags of resiliency, there might be better scope for 10-year yields to soar rather than drop. Considering that 10-year Treasuries now offer 3.47%, yields could test the upper range at around 3.7% if yields break above the short-term falling trend line. The loss an investor would suffer is approximately 2 cents on the dollar.
Yet, if yields break below their 3.28% support driven by a gloomier economic outlook, they might find support next at 3%, potentially bringing a gain of 4 cents on the dollar.
Everybody must ask themselves whether it's best to prefer long-term U.S. Treasuries or T-bills. While that is a personal choice that one needs to make, it's essential to consider that: