US Treasuries and Yields

Rising Treasury Yields have been a hot topic in the past few weeks, which is blamed to be the reason behind recent  market correction. Some people are totally panicked as 10-year yield approaches 3%. I would suggest to "Keep Calm and Carry On". In this article, I would like to give you some background, and possible trend.

US Treasuries

Basically US treasuries, including short-term and long-term, are the national debt of United States (国债). US currently have debt of $20T. Debt/GDP ratio is 104% in 2017, as shown in the chart below (grey bars represent recessions). As comparison, China Debt/GDP ratio is 46% in 2016; Japan is 238%.

The debt falls into two broad categories: Intragovernmental Holdings and Debt Held by the Public.

Intragovernmental Holdings $5.6T, 30% of total. This is the portion of the federal debt owed to 230 other federal agencies, such as the Social Security Trust Fund. This part is not affected by market.

Debt Held by the Public $14.7T, 70% of total.

• 50% of that is owned by foreign governments and investors
• 25% is held by Fed and state/local governments
• 15% is held by mutual funds
• 10% is held by businesses (banks, insurances)

Why Treasury Yields Are Important?

Interest rates on ALL other domestic bond categories rise and fall with Treasuries, which are the debt securities issued by the U.S. government. For example, the 30-year mortgage rate historically runs 1~2% above the yield on 30-year Treasury bonds. Current 30-yr mortgage rate is 4.5%, 1.3% above 30-yr treasury (3.2%).

In other words, high yields mean high mortgage rates, high credit card interests, high company/government bond yields, high borrowing cost for companies to invest into new business,  slowdown of business activities, inflation....

It seems that high yields do nothing good. However, things do not change overnight. A strong economy can support yields to certain level without slowing down. It is important for us to look into treasury yields history.

Treasury Yields History

Let's look into 10-yr treasury yield since 2000 in the chart below, compared to the market indices. It has been a downtrend. 

• The yield was 6% at the start of 2000. 
• From 2003 to 2007, we had a good economy and stock market with relatively high yield ~4%.
• The sky-fall in 2008 is caused by the Great Recession. Money flooded into bonds as stock market crashed. Fed quantitative easing (QE) started in late 2008.
• It has been below 3% from the second half of 2011. 
• The housing market started to turn around in 2012 as yield hit bottom.
• The jump in 2013 was caused by the Fed announcement of  tapering back its QE program.
• The other jump in 2016 was probably caused by the election tension (uncertainty).
• The most recent hike started as Fed decided to shrink balance sheet.

One conclusion we can draw is that current treasury yields are still historically low at this point.

Timeline of QE and Unwinding Plan

Beginning in late 2008, the Fed (under Chair Ben Bernanke) began large-scale purchases of assets such as U.S. treasuries and government-supported mortgage-backed securities (MBS) to stave off a complete collapse of the financial system, known as quantitative easing (QE). For the next 6 years (3 QEs), the Fed managed to keep interest rates at record-low levels in the hope that increased bank lending would spur growth. 

In May 2013, the Fed announced it would taper back its QE program. The announcement caused panic selling in U.S. Treasury markets and interest rates surged higher. The day became known as the taper tantrum. 

On Oct 29, 2014, when Fed Chair Janet Yellen announced the end of the bond-buying program, the Fed's balance sheet had reached $4.48T. Since then, the balance sheet has remained about $4.5T. Its balance sheet consists of $2.5 trillion in treasuries and $1.8 trillion in MBS. 

Trump has been highly critical of Yellen and the Fed's low interest rate policy and if he chooses to shake up the Fed it could shift the strategy of the central bank. "This could be important for balance sheet policy because many Republican-leaning economists have criticized QE and have expressed a preference for rapid balance sheet rundown, perhaps even through asset sales," Daan Struyven, a Goldman economist said, according to CNBC. 

In a 2017 January blog post titled "Shrinking the Fed's balance sheet," former Fed Chair Ben Bernanke warned against the Fed actively trading its balance sheet. "I worry though that, in practice, attempts to actively manage the unwinding process could lead to unexpectedly large responses in financial markets," Bernanke said.

Instead of selling the holding treasury assets, Fed can just let the treasuries mature, which is a milder way. It is worth noting that $1.4 trillion of the $2.5 trillion in Treasuries have maturities of less than five years. 

At the Fed 2017 June meeting, committee members stated that once tapering begins they will start by letting $6 billion a month in maturing Treasuries run off, which will slowly increase to $30 billion over the coming months. With regards to its agency debt and Mortgage-Backed Securities (MBS), the Fed laid out a similar plan where it will begin tapering $4 billion a month until it reaches $20 billion.  Additionally, the Fed said the long-run plan is to keep the balance sheet "appreciably below that seen in recent years but larger than before the financial crisis."

On Sep 20, 2017, the Fed officially announced lift-off. The unwinding of the balance sheet was underway. The $50 billion per month taper would begin in October, and at this rate, the balance sheet would drop below $3T (from $4.5T) in 2020. The reduction of $1.5T represents ~10% of current public market total ($14.7T).

Foreign Governments' Holding

US Treasuries are considered one of the safe havens because it is backup by strong US economy. Foreign governments hold $6.3T by 2017, increasing $0.4T. The month-by-month 2017 chart is shown below. If they can keep buying at the same speed, the number can grow to $7.5T --- making up the unloading from Fed.

However, we have noticed the slowing down in Nov 2017, which is caused by the selling by China and Japan. China has become the largest holder, Japan is second. Their holdings are shown below.

• China became No.1 in June
• Japan started unloading in April
• China started unloading in Sep

Mistakes by President Trump

1). Ask Fed to hike rates and shrink balance sheet. I have explained the reasons above why it is bad.

2). Issue Tax-cut in a bad time: huge government deficit adds pressure to treasury.

3). Allow US dollar to be devalued: US/CNY has dropped from 7 to 6.3. Falling US dollar makes its treasury notes less attractive for international buyers. US dollar value has fallen -12% since Trump became President. Treasury secretary Steven Mnuchin and President Trump seem to have zero understanding the importance of dollar strength.

4). Ignite Trade Wars with China. Instead, US should beg China to buy its debt to calm down the rising yields.

5). Propose $1.5 Trillion Infrastructure Plan: it is literally adding oil to fire.

What's Now?

In the past week, US Dollar seems to be stabilized, which can encourage foreign gov/investors to buy treasuries again. The correction and volatility in stock market may also push investors to move money into bonds. I expect the 10-yr treasury yield to stay around 3% in near-term. It has been nearly flat last week @ 2.86%.

 A dovish tone on rate hikes from Fed and other central banks is needed. The current inflation in US is about 2%. They shouldn't rush to hike interests aggressively.

A slimmer Infrastructure Plan is welcome.

Conclusions

Rising treasury yields are very important. It is harmful to our economy. It is caused by Fed unwinding plan and devaluation of US dollar, along with Trump government mistakes.

Current yields are still historically low, and could be stabilized (if government makes less mistakes).

At this moment, stay calm and pay closer attention to it.