The changing character of US Treasury notes

Peter Warburton - 7 March 2019

For many years, the US benchmark 10-year Treasury bond has occupied a unique and seemingly unassailable place at the heart of the global financial system. The US has made a virtue of fiscal incontinence, arguing that the world should be grateful for a Niagara-style supply of these lovely liquid coupon-bearing instruments struck in the mighty US currency.  However, net foreign purchases of US Treasury bonds, which reached an annual pace of US$800bn in 2010, have disappeared for the past 3 years, leaving US banks and domestic investors to pick up the confetti. How confident can we be that US Treasuries are still a safe, or even a protective, asset?

My thesis rests on five arguments: first, that there are structural reasons why US Treasury notes have become less attractive to international private and official investors. Second, that the global responsibilities assumed by the US have become unaffordable alongside its severe domestic demographic and distributional challenges, leading to a realised and prospective deterioration in the US fiscal position. Third, the extreme difficulty encountered in reflating the US economy has provoked a serious discussion about relaxing the inflation objective to correct undershoots. Fourth, bondholders face idiosyncratic risk in owning US notes in the face of changes to the size and composition of the Fed’s balance sheet. Fifth, as a matter of record, the diversification benefits from owning US benchmark bonds in periods of US equity market drawdowns have eroded in recent years.

Foreign investors – from central banks and sovereign wealth funds to large insurance and pension funds and collective investment vehicles and hedge funds – have been re-evaluating the place of US Treasury bonds in their portfolios. The motivations include a desire to diversify out of US Dollar assets, a willingness to take more equity and credit risk, a desire to shift asset allocations to tangible assets and reflect the impediment of soaring hedging costs.

The US fiscal outlook has worsened alarmingly in recent years as fiscal conservatism has been beaten back and new spending priorities have emerged, such as infrastructure renewal and the migration to clean energy. The US is still the military guardian of roughly a quarter of the world’s population and is spending heavily to sustain leadership in martial potency and military technology. With around 40m Americans dependent on food stamps, an opioid crisis and Illinois heading for junk bond status, the fiscal challenge is escalating.

Richard Clarida, vice chair of the Federal Reserve, is leading a review of its monetary policy strategy, tools and communication processes to be completed around the beginning of next year.  He has provided strong hints that so-called “make-up” strategies, where policymakers seek to compensate for past deviations of inflation from target, will be adopted. Any relaxation of the Fed’s inflation framework is bound to unsettle long-term holders of US Treasury bonds.

Simultaneously, the Fed is talking openly about the optimum size and preferred composition of its balance sheet. The market is already priced for a curtailment of its market sales of MBS and Treasuries, but its Treasury portfolio has a weighted maturity of 92 months as opposed to 65 months for private investors. Unless the Fed is willing to lengthen its average maturity further, its sales will continue to be weighted towards the 10-year maturity.

Finally, there is the practical matter of the usefulness of US benchmark bonds in portfolio construction. To what extent do bond returns, due to a negative contemporaneous correlation with stock returns, improve overall investment returns and reduce variability? Figure 1 presents the results of an examination of the increase in benchmark bond returns that occurred during episodes where the S&P 500 return index lost 5% or more of its value. For reasons that are not entirely clear, the degree of protection offered by bonds to an equity portfolio has been greater during periods when the WTI oil price has been falling. However, over the past 5 years, the typical benefit derived from holding bonds when equities are falling has dropped from more than a half of the S&P loss to less than a quarter. 

However slowly and subtly, the US benchmark bond is losing its fundamental appeal and its practical usefulness in portfolio construction.

Figure 1

Data source: Thomson Reuters Datastream

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