4 Reasons Treasury Yields Can Fall Further

A confluence of factors is contributing to distortions in the U.S. Treasury market

Conventional wisdom tells us that interest rates have nowhere to go but up. The depressed yields on U.S. Treasuries are at trading at historic lows and the Federal Reserve can’t manipulate interest rates below zero percent.

But conventional wisdom about the U.S. Treasury market by many of the market’s best minds has been badly wrong.

Look no further than Bill Gross, founder of PIMCO and one of the savviest fixed-income investors anywhere.

In 2011, Gross famously proclaimed that U.S. Treasuries offered no upside and it was time to bail. Treasury investors are destined "to get cooked like frogs in an increasingly hot pot of water,” are the exact words he used at Morningstar’s 2011 Investment conference. Later that year, Gross issued a rare apology to investors for betting against U.S. Treasuries.

The iShares Barclays 20+ Yr Treasury Bond ETF (TLT), which tracks long-term U.S. Treasuries, ended 2011 higher by an amazing 33.96%.

What does this show? That Treasury yields are low and can head even lower. And since Treasury prices and yields move in opposite directions, lower yields translate into higher prices.

As I see it, a confluence of factors is contributing to distortions in the U.S. Treasury market. And contrary to what the convention wisdom is saying, these marketplace distortions could become even more extreme due to the following four reasons:

--The Federal Reserve’s extension of Operation Twist. Here’s what it means: The Fed will rotate into longer-dated Treasuries (generally 7 years +) from maturing short-term Treasury debt it owns. Buying U.S. debt is artificially boosting the price of Treasuries and keeping yields in check.   

--The declining creditworthiness of European governments. Bond investors are fleeing Europe’s eroding credit quality. And the relative safety of U.S. Treasuries is still their favorite destination. Demand for Treasuries is driving up prices and suppressing yields.  

--U.S. yields vs. the Globe. A comparison of yields on 10-year U.S. Treasuries relative to competing government debt with similar maturities shows that Treasury yields can fall further. If fixed income investors are going to lend Japan money on a 10-year note at 0.86 percent, why wouldn’t they extend the same favor to the U.S.?

--Behavioral finance. When the crowd thinks, as it does today, that Treasury yields can’t fall further – the opposite is usually true. And betting against the crowd almost always pays. 

                                                                          Source: Bloomberg, June 2012

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