Long-term U.S. Treasuries might outperform during a debt ceiling crisis, but the stakes are high Long-term U.S. Treasuries might outperform during a debt ceiling crisis, but the stakes are high Long-term U.S. Treasuries might outperform during a debt ceiling crisis, but the stakes are high

Long-term U.S. Treasuries might outperform during a debt ceiling crisis, but the stakes are high

Bonds
Althea Spinozzi

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. 

Source: Bloomberg and Saxo Group.

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:

Today, the conditions for a large U.S. Treasury rally might not exist.

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.

The devil is duration.

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.

Source: Saxo Platform, courtesy of Kim Cramer.

Conclusion: U.S. Treasuries upside possible, but at a much worse risk-return ratio

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:

  • It's hard to see why one is willing to take a much higher duration risk while the pickup short-term T-bills provide over longer-term Treasuries is the largest on record (going back to the beginning of the 90s). Three-month T-bills are now offering 170bps over 10-year yields.
  • T-bills remain one of the safest instruments available to investors because the Treasury will do everything possible to avoid a default. As it is well discussed in congressional documents prepared by the Federal Reserve Bank of New York before the Senate Finance Committee testimony of August 2011, the Treasury is prepared to prioritize debt principal and interest payments (P&I) over any other payment. As the document states: “Treasury securities that are maturing would be funded by having auctions that would roll over those maturing securities into new issues, so the new issues would be able to fund the redemption of the maturing securities. With respect to interest payments, the way the Treasury planned to ensure that it would be able to pay interest payments timely by holding back other government payments and accumulating sufficient cash balances in its Fed account to pay upcoming coupon payments. The implication of this approach would be that the Treasury would be delaying non-P&I payments even on days when it may have ample balances in its Fed account to have been able to make those payments if it had so chosen. Instead, the Treasury would be conserving that cash to be able to ensure that it would be able to pay future-dated interest payments. Then, to ensure that payments made would settle as usual, the Treasury would not submit any ACH files to the Reserve Banks for processing unless it was certain that it would have sufficient balances on the settlement date to settle those transactions. Similarly, for checks, the Treasury would not mail checks out to the intended recipients until it was sure that it would have sufficient balances in its account to fund the presentment of those checks once they came back to the Fed. And for Fedwire funds transfers, the Treasury would not make funds transfers unless it had sufficient balances in its Fed account to do so.”
  • Investing in shorter maturities might give the flexibility to investors to invest in upcoming opportunities.
  • As U.S. Treasury yields are rangebound between 3.28% and 3.70% since mid-March, there might be little upside to engage in high-risk long-duration trades.
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