September 7, 2010
Have yields bottomed out?
With the non-confirmation of the new low in the two-year, and the matching of the low in the five-year, it looks like we're carving out a very long-term bottom in interest rates. I say long-term because we are talking about the reversal of nearly a 30-year trend. This carving out of a new low is almost two years in the making, from late 2008 to the fourth quarter of 2010. It probably could stretch on into 2011.
Let’s start with the premise that I'm fond of now, that you're not going to go to a new low on the ten-year. Once you are at 2.45%, then there's not much profit potential left, and you are starting to get a very, very negative risk-reward set up in the Treasury bond market. That is pretty much un-debatable. When you think about the two-year Treasury yielding 50 basis points, the total return that one will receive holding it for two years is 1%, a half a percent a year.
Whenever people talk about comparing one market to another over a two-year time frame, if market “A” has a return within one percentage point of market “B,” most people would say they are the same. They wouldn't say, “oh look, this market did a full whopping 1% better than this other market. What a dominating performance!”
The two-year Treasury basically is going to give you a cash return. It has no chance of giving you anything that would be remarkably different from a cash return. It only has a chance of costing you from an opportunity perspective, if you think of a CD or something you'd lock in for two years that might have a penalty. It's not like you're going to lose money on the two years. It's more of an opportunity cost. Over the next two years I'd like to think that any investor will find some short-term opportunity that will have a risk-reward profile better than a 1% return.
For example, home-building stocks are down a lot and facing bad fundamentals, but at any moment they could have a 25% price increase. I'd rather have my powder dry to participate in that, than just stick money into something that's going to give you effectively a 0% return for two years. The risk-reward on short-term bonds versus cash in the Treasury market is terrible.
The ten-year Treasury went through 2.5% and it's struggling with that level, but it's down near that low. What are you really hoping for here? That it goes to 2.25%? I'll acknowledge that the ten-year Treasury could certainly make it to 2.25%, maybe even a little lower, but who cares? That's a 20 basis-point drop in yield. So what? You make a percent and a half capital gain. Big deal!
The risk-reward set up against this divergence on the yield curve looks poor in Treasury bonds. We've been looking at this long-term carving out of a bottom taking place. It really became an asymmetrically negative risk-reward once the ten-year went below 2.5% from our point of view.
I just want to be clear – are you are bearish across the yield curve? It's not just the two-year or the five-year?
I'm not bearish. This is too long-term of an idea to say that I am losing sleep at night because I am bearish on the Treasury market. There are no real problems in owning the Treasury market. We are carving out a bottom. It may take another nine months before you start to see rates go up. As an investor who allocates money across bond portfolios, once the ten-year is below 250 basis points, I don't really see the risk-reward set-up versus other opportunities in the market as being sensible.
One of the things that we are expert in is in mortgage-backed securities. In the non-guaranteed mortgage market, we feel highly confident that we can make investments that will return 7% to 9% per year. How in the world am I going to get a higher return from the ten-year Treasury than that? This year you did. It was okay to own the ten-year year to date, because the yield dropped from 4% to 2.5%, creating a total return of over 15%. Not only did you have the potential, but the reality is you received a 15% return on a ten-year Treasury from April through today and even higher on 30-year Treasury bonds.
Going forward, however, the math just doesn't work. The capital gain potential is too small. The interest income is too small to sum up to something that is better than opportunities away from the Treasury market.
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