Mortgage Rates & European Vacations


Posted in: Economics, General, Stock Market, Thought of the Week

The U.S. Government debt market, also referred to as the U.S. Treasury market, is one of the most important financial markets in the world because Treasury prices determine the base price for so many different assets.

Last year was a shockingly strong year for U.S. debt, where the 30-year Treasury gained 30% in value and caught most of Wall Street off guard. As we enter the New Year, one of the key controversies involves the future of Treasury bond yields, which are influenced by three key factors:

  1. The Fed’s monetary policy
  2. Investor demand for U.S. debt
  3. The amount of new debt issued by the U.S. Treasury Department

 

Let’s analyze each of these factors in order to predict the near-term direction for Treasury prices and yields. Bond prices move inversely to their yields, so as the yield on a bond rises, its price falls and loses money for the owner of that bond.

Fed policy is critically important to longer dated Treasury bonds, in particular the 10-year and 30-year U.S. bond, because a rise in the short-term rate (controlled by the Fed) will result in an outsized move up in long-term yields.

Since the Fed will likely keep short-term rates at or near zero through the end of the year, the risk of falling Treasury prices and rising Treasury yields on account of Fed action is quite low.

Next, let’s compare supply against demand because the battle between these two is the driving force behind the price of nearly every asset class that is freely traded. Starting with the demand-side, our Investment Committee expects the demand for Treasuries to remain very strong for three key reasons:

  1. Financial Institutions: New regulations are requiring banks, insurance companies, and other large financial institutions to hold more liquid assets to prevent another financial crisis. The buying from these entities will likely continue as they de-risk portfolios.
  2. Relative Attractiveness: Long-term government debt in other countries like Japan and Germany are paying a fraction of the yield offered from U.S. debt, and these countries have neither the depth nor the breadth of the Treasury market. Hence, on a relative basis, Treasuries pay higher yields and carry lower risk than all other large, developed countries.
  3. Safe Haven: The U.S. Treasury market is by far the most liquid financial market in the world, and investors across the globe come here knowing that they can buy/sell freely when fear and panic enter riskier markets.

 

Simply put, Treasuries offer the most attractive yield on a risk adjusted basis of any major economy in the world, and this demand should remain strong for the foreseeable future.

A country issues debt when its government intends to spend more money than what they will bring in through tax revenues. For example, if a country determined that they need to spend $10 billion in 2015, but only $7 billion in revenue from taxes was projected to be collected, then the government would need to issue $3 billion in debt to cover the projected expenses ($10 billion – $7 billion = $3 billion).

The net effect of supply unable to meet demand in the Treasury market can be witnessed in the “bid-to-cover” ratio, which is the key measure of demand for Treasuries.

This ratio compares the amount of demand against the available supply of Treasuries at the most recent auction. The higher the bid-to-cover, the more demand exists for Treasuries. Currently, this ratio is at 3.0 for the 10-year Treasury, which is a historical high and supports the conclusion that demand for U.S. debt remains well ahead of supply.

As with most predictions in financial markets, the impact to investors will be mixed. Here are the three main ways our Investment Committee sees lower Treasury yields (higher prices) affecting investors going forward:

  1. Mortgage Rates Will Likely Fall: Declining yields on longer dated Treasuries will most likely drive down mortgage rates even further. Those in the market to buy a home should take advantage of these low rates over the next 12-18 months before the Fed acts.
  2. Income Generation Will Get Tougher: Falling yields will make income generation even more difficult, and income seeking investors will need the help of an active manager to navigate the added risk required in a portfolio to find attractive yields.
  3. The U.S. Dollar Will Get Stronger: Since our debt is so attractive on a relative basis, foreign investment should continue to come to the U.S., which will strengthen our dollar even further. Investors who are thinking of visiting Europe should benefit in 2015, as the Euro and U.S. dollar approach parity.

The bottom line is that demand for U.S. debt should exceed supply for the foreseeable future, which will drive Treasury prices up and their yields down. Since so many financial assets use Treasuries as a base for their own value, we expect the yields in several sectors of the bond market to also follow suit.

Therefore, our Investment Committee has positioned our conservative portfolios to benefit from falling Treasury yields for 2015, and they will be watching the interest rate environment very closely and adapt as we approach the day when the Fed finally enacts the first rate hike since 2006.

Read this week’s Thought of the Week to learn more about U.S. Treasury prices and their affect on our economy.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.