U.S. Treasury Bonds Are Set to Beat Stocks
Economic data and the probable Fed policy point to attractive returns for holders of long-dated bonds.
(Bloomberg View) -- Several developments last week indicated that the recent panic in the market for U.S. Treasury bonds was a false alarm. The increase in average hourly earnings has slowed appreciably, reducing the risk of aggressive monetary tightening by the Federal Reserve. Inflation moderated from levels recorded at the beginning of the year. Retail sales dropped for a third month, belying expectations of an increase. Finally, data released March 16 showed that February housing starts fell more than expected, providing another indication of slower economic growth.
In response, yields on 10-year Treasuries fell from a peak of 2.95 percent on Feb. 21 to 2.85 percent on March 16 (chart below). The message to investors from the confluence of the economic data and probable Fed policy for the rest of this year is that holders of long-dated Treasuries should receive attractive returns as equities get hit. High-grade fixed income securities are also likely to be a haven from the fallout in global equity markets from disputes between the U.S. and its trade partners.
The Fed has suggested that it may increase the federal funds rate at least three times this year. With inflation and economic growth insufficient to support monetary tightening, the spread between yields on two- and 10-year Treasuries could go negative by the end of the year -- another bond-positive development. The spread has already shrunk from a recent high of 78 basis points on Feb. 12 to 55 basis points on March 16.
The most recent period of turbulence began when employment and wage data released on Feb. 2 showed average hourly earnings accelerating to 2.9 percent in January from a year earlier, up from a 2.7 percent gain the prior month. In February, I predicted higher bond yields were unlikely to last because the same jobs report showed that the average workweek had dropped sharply and workers took home smaller weekly and monthly pay packages.
The shift to more bond-friendly market sentiment began with data released March 9 showing the rise in average hourly wages moderating to 2.6 percent last month. Data released March 12 showed that the monthly inflation in headline consumer prices slowed to 0.2 percent in February from 0.5 percent in January. Inflation in producer prices also slowed according to the latest figures released March 14.
For investors, it matters that that the prognosis for lower Treasury yields was not based on inflation alone. There was also a shift in expectations regarding the pace of economic growth. An unexpected drop in retail sales last month was announced on March 14. Those weak numbers cast doubts on the optimistic forecasts for growth. They also suggest that consumption spending, which accounts for about 70 percent of gross domestic product, is not as strong as previously believed.
The Federal Reserve Bank of Atlanta, highly regarded for its “GDPNow” forecasts, promptly revised its expectation for the first-quarter increase in consumption expenditures to 1.4 percent from 2.2 percent. The forecast for GDP growth during the quarter was reduced to 1.9 percent. At the beginning of February, the Atlanta Fed expected growth would be as high as 5.4 percent.
New trade sanctions that the Trump administration is planning could also prompt retaliation and dampen growth. In reaction to the increase in the U.S. trade deficit with China to a record $375 billion in 2017 from $347 billion in 2016, U.S. officials have asked China to lower the deficit by $100 billion. In one of his first interviews after being named President Donald Trump’s director of the National Economic Council, Larry Kudlow said China “has earned a tough response” from its trade partners.
This means there are likely to be additional restrictions on Chinese exports on top of the already announced tariffs on exporters of steel and aluminum. The White House is said to be considering a levy of $30 billion to $60 billion on Chinese goods. This will almost certainly prompt retaliation by China affecting U.S. exporters and companies. China’s Foreign Minister Wang Yi has indicated that his country would have the “necessary response” to any U.S. tariff measures.
In making allocations across bonds and equities, investors should pay heed to the confluence of moderating price increases, slowing economic growth, and the growing likelihood of a trade war. Each development, by itself, would be negative for equities and positive for high-grade fixed-income instruments. All three occurring simultaneously over the coming months could be a perfect storm.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Komal Sri-Kumar is the president and founder of Sri-Kumar Global Strategies, and the former chief global strategist of Trust Company of the West.
To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.
For more columns from Bloomberg View, visit http://www.bloomberg.com/view.
©2018 Bloomberg L.P.