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You Can't View Treasurys Through the Typical Prism

Don Ellenberger

Normally, investors try to determine value in the U.S. Treasury market by looking at GDP growth, inflation levels and related metrics. Over the long term, these fundamental macroeconomic forces are what typically drive interest rates and Treasury bond prices.

But as is particularly obvious these days, a lot of other factors can influence the direction of interest rates over the short term. With the Federal Reserve adopting an extremely accommodative monetary policy stance built around a zero interest-rate policy (ZIRP) and quantitative easing (QE), the usual ways of valuing Treasurys have been thrown out the window.

The idea behind ZIRP (aimed at keeping the target federal funds rate and generally all short rates at or near zero) and QE (monthly purchases of $85 billion in long-term Treasury and agency mortgage-backed securities) is basically what the Fed calls the "portfolio balance channel effect." That's economic-speak for pushing rates on presumably risk-free government securities so low that investors will want to buy riskier investments--equities, particularly dividend stocks; investment-grade and high-yield corporate bonds; even real estate--just to find some return.

There is a method to this Fed policy madness: it simply wants to stimulate risk-taking to stimulate growth. Think of it this way: if investors start buying stocks, stocks should go up in price, creating a "wealth effect," i.e., higher stock prices help investors feel wealthier, making them more likely to spend more. If they spend more, demand rises, prompting companies to invest and hire more. Thus begins a virtuous cycle: more hiring equals more income equals more spending equals more demand equals more hiring ...

It's not just investors feeling the Fed's tug. By keeping rates so low, it's also trying to spur more bank lending--there's not a lot of money to be made for banks that just sit on their cash. Yes, the amount of interest they pay for deposits may be at record lows, but thanks to the Fed, so are the yields they receive on their security portfolios. With this margin squeeze pinching profits, the hope is banks will start taking on more risk by lending more to a broader range of borrowers, particularly small businesses. That's particularly important because small businesses create most of the economy's new jobs. In a similar vein, the Fed is acting to spur housing by keeping mortgage rates at historic lows, too.

All of this is being done in response to the global financial crisis that spawned the worst U.S. recession since the Great Depression, fueled fears of deflation and sent unemployment soaring. Fed Chairman Ben Bernanke and his team have been very clear they are willing to do whatever it takes to restore balance and meet the central bank's dual mandate of promoting price stability and maximum employment. They've even set very specific targets for these two goals--up to 2 percent for inflation, with leeway to go as high as 2.5 percent, and 6.5 percent or lower for unemployment. There's little reason to believe policymakers will let up on the gas until they meet, if not exceed, these targets.

To be sure, it's not just the Fed confusing Treasury valuations. A recessionary Europe, the slowest rate of growth in the Chinese economy in 13 years and the fiscal drag from both higher payroll and income taxes that hit in January and from sequestration's government-mandated cuts are acting as growth and rate depressants. Then there's the Bank of Japan. To help pull that country out of a two-decade funk, it has undertaken a quantitative-easing program that, as share of GDP, is even more massive than the Fed's--the thinking is some of that Japanese liquidity will find its way into U.S. Treasuries. And there's always the "haven" trade. For all our troubles, the U.S. dollar still acts as the world's reserve currency, which means whenever anything bad happens in the world investors still flock to Treasurys for security. It's a big world and bad things happen all the time.

Ironically, the Fed's determination to force government interest rates as low as possible carries within it the seeds of its eventual reversal. If the Fed is successful in stimulating economic growth, organic pressures for rates to rise will intensify, much like a boiling pot. Eventually the lid will pop off, the Fed will withdraw the monetary punch bowl, and rates will rise, likely generating losses for holders of longer term Treasury bonds.

But that's a story for another day. For now, the world is still in a very fragile place. So stop trying to view Treasurys through the typical prism--in this atypical environment, it won't work.

Donald T. Ellenberger is senior portfolio manager and head of multi-sector fixed income at Federated Investors. With more than 26 years of investment experience, Donald is responsible for portfolio management and investment research for fixed-income mutual funds and separate accounts. He earned an MBA from Stanford University.

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