Treasury Bonds: Last week was quite a week for Treasuries! The yield on the 10-year Treasury note closed last Monday at 2.92%. At Friday’s close, the yield had increased to 3.32, a 40 basis point spike! Dropping the bond market jargon, (and if ever there was an industry that loves jargon, bond traders have to be in the front of that line) this means that the effective interest rate that a buyer demands in order to purchase a 10-year Treasury increased by 14%. That’s an awfully big jump. Today the 10-year opened at 3.332 and hit a high of 3.371. As you can see from the chart below, we are experiencing more changes in the yield on the 10 year in recent years. Yields have increased 78 basis points from October 1st, 2010 and are back to May 2010 levels after their drop during the summer and fall. (Chart is from 12/99 through the current rate using Federal Reserve Data)
This increase is particularly noteworthy when volatility dropped 2.2% and the S&P500 rose 1.3% and has reached a new 52-week high. Bonds yields don’t typically rise like this when volatility is dropping and equities are rising. I propose the rise is due to the bond market adjusting to a shift towards inflationary pressures vs. previous recession/deflationary expectations and possibly also reflects the proposed tax rate extensions coupled with increased government spending. Last week we also learned that the federal deficit increased from $120.3 billion in November of 2009 to $150.4 billion in November of 2010. For the current fiscal year, the deficit is $290.8 billion which is $5.8 billion less than in the previous fiscal year. Translation expectations of an increase in federal debt means Treasuries need to pay more to be attractive. The FOMC (Federal Open Market Committee) meets Tuesday, which will certainly have investors’ attention.
In an interview last week with Bloomberg News, former Fed Chairman Alan Greenspan cited a historically large buffer between the level of our federal debt and our capacity to borrow that is narrowing. In explaining the smaller buffer, Greenspan pointed to the huge overhang of federal debt which we have never seen before. He called Treasury yields a canary in the mine. The supply of debt is increasing; demand may not keep pace.
Who are the leading demanders of US debt? According to data provided by the Treasury Department, China is largest foreign holder of US Treasury notes, followed by Japan. The United Kindgom and the major oil exporting nations are other leading buyers. China’s position has held over the last year. As foreign holdings have grown my roughly 20 percent, China’s holdings have grown in kind.
What does this mean? As expected, interest rates look to be increasing. This doesn’t mean that we won’t see the occasional short-term drop in the future, but overall we expect the general trend to be increasing, not withstanding significant shocks to the system such as terrorist acts or further euro-crisis revelations. This is particularly troubling for our domestic economy as Pierre Cailleteau, head of Moody’s sovereign ratings, argued in a Financial Times article that the size of debt makes the U.S. vulnerable to an interest rate shock.
Earnings: According to Thomson Reuters, 73% of the companies that have reported third quarter earnings reports had results that exceeded the consensus earnings estimate, which is noticeably higher than the norm in a typical quarter of 62%, (according to Thomson Reuters dating back to 1994).
What does this mean? The various cost cutting measures companies enacted during the financial crises have been paying off, however we don’t expect 2011 to have such strong earnings growth as the effect of government stimulus fades, unemployment continues to drag on the economy and the impact of cost-cutting is diminished.
There are still significant fundamentals problems in both our domestic and global economies. How those problems are worked out and on what time frame is decidedly unclear. Given this lack of clarity, we remain committed to a strategy that seeks to generate returns that do not depend on strong economic growth.