Saturday, January 21, 2012

Treasury yields likely to rise in 2012

This week we finally saw a sell-off in longer term treasuries after a relentless rally. With a great deal of new supply hitting the market, US treasuries will be under further pressure going forward.  Here are six reasons that make higher yields more likely in 2012:

1. In 2010 the onset of QE2 pushed treasury yields lower (within a month of the Jackson Hole announcement the 5yr yield was lower by 16bp).  As discussed earlier however, the probability of a quantitative easing redux has declined markedly.

2. Operation Twist which has been providing support to longer term treasuries is expected to end this summer.

3. Many managers who were short or under-invested in treasuries (such as PIMCO) have capitulated, as treasuries continued a powerful rally in 2011. Investors have been trying to short US treasuries for some time with the view that QE programs will ultimately debase the dollar and accelerate inflation. These projections did not materialize and the capitulation trade caused treasuries to rally further. The chart below shows shares outstanding of the ProShares Treasuries 20+ Year UltraShort ETF (ticker: TBT). It allows investors to easily short longer dated treasuries on a leveraged basis. The capitulation trade is clearly visible in the decline of the number of shares outstanding.

TBT shares outstanding (Bloomberg)

The Long Bond became known in some trading circles as the "widow maker" because of the losses numerous traders endured trying to short it. Many have since said "no more!"  Now with fewer shorts in the market, there will be less support for treasury prices going forward.

4. Treasury yields have decoupled from "risk assets" such as equities. This is unlikely to be sustainable going forward.

5. Between the Fed's Liquidity Swap and the numerous actions by the ECB, the funding pressures in the eurozone have receded materially. Yet treasuries have not adjusted accordingly. The chart below compares 10-year treasury yield with the 3-month EUR/USD basis swap rate.

10-year treasury yield vs. EUR/USD 3m basis swap spread (Bloomberg)

6. Even though foreign private investors continue their love affair with treasuries, it seems that foreign central banks may be losing their appetite for US government debt. Treasuries holdings at the Fed by foreign central banks are showing declines.

Foreign banks' holdings of US treasuries at the Fed  (Bloomberg)  

There is no shortage of new supply, as the US Treasury is expected to hit the market with net new issuance of about $81bn/month excluding what the Fed is expected to purchase (see Businessweek - forecast by Credit Suisse). Clearly an unexpected shock in Europe could trigger a new rally in this market, but absent such an extreme event, longer term treasury yields should rise in 2012.


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