The US Treasury Fakeout

Global bond market volatility was at a relative extreme this week. Following the markets you would see headlines like this:

The basic premise being that the world is awash in liquidity and as a result of the prices of government bonds, investment grade bonds (IG), and high yield (HY), have been bid so heavily that the yields of these instruments no longer reflect the credit and/or currency risks associated with the issues. 

Of particular interest to me was the relentless selling in USD based assets especially treasuries. 

$TYX=30 year, $TNX=10 year, $FVX=5 year, $UST2Y=2 year

As an investor the question became "Is this the beginning of a new trend or a false (counter) trend within the larger trend?". To answer questions like these I try simplify the logic. 

  1. Are the other global central banks committed to active devaluation of their currencies while the FED is not? Yes, they are. That's (USD) positive. 
  2. Do current global market conditions allow for gray (black) swan events? Yes.
  3. Given a gray (black) swan event, which markets are creditworthy as well as deep and liquid enough to absorb multiples of Billions of investor capital in a 'flight to safety' response? The U.S. government bond market is the only one to meet all the aforementioned criteria. Again (USD) positive. 
  4. Examining bond yields relative to credit/currency risk are there more attractive international government bond instruments available? No. Even with the recognized overvaluation in US bonds US gov't yields are still the most attractive relative to credit/currency risk.

Currently examining the chart only Portugal, and Australia are offering better yields than the US 10 year. Clearly risk is being artificially repriced according to central bank machinations. Keep in mind Eurozone member bonds were priced for default within the last 24 months. Now government bonds in Spain and Italy are priced as if they represent better credit risk than the US! That's pure foolishness.

As a fixed income portfolio manager you can't find a better setup.  As a result it is my belief that the previous sell-off in global bond markets represented more rotational and risk management behavior as opposed to a new trend. Again, put yourself in a fixed income PM's shoes. You have a multi-billion dollar bond portfolio to manage, your options are limited in terms of investable markets. The best credit risk in the world (USD) is yielding higher than 80% of your available options. On a relative basis you better believe there will be a bid under treasuries as long as the current capital market framework is in place. 

Examining the % change in yields of US treasuries from their Wednesday highs to Friday's close, it appears as if portfolio managers were moving to the shorter end of the curve as the 2, 5, 10 year all outperformed the 30 year.