Off The Charts! examines the pertinent economic issues of the day, providing a deeper dive into complex topics and framing the issues in a way that can lead to a better understanding of the financial and commodities markets.
Are U.S. Treasuries undervalued? That might sound like an absurd question if you consider: the 10-year Note has a yield of not far above 2% and the 30-year bond is yielding just less than 3%; the Federal Reserve (Fed) is in the middle of a tightening cycle that involves both raising interest rates and soon, perhaps, curtailing reinvestment of its massive balance sheet. Even if yields returned to their early 2014 levels, they would be 90 basis points (bps) higher on 10-year notes and 115 bps higher on 30-year bonds.
So, can a case be made that U.S. Treasuries are undervalued? First, compared to their equivalent in other developed economies, U.S. Treasuries remain among the highest yielding, especially among AAA-composite rated bonds. Second, despite an eight-year equity bull market, U.S. Treasuries have performed decently for investors, and have exhibited negative correlations to equity markets during that time. Third, as equities continue to rise, they are decoupling from corporate earnings, which might signal either a period of higher volatility or eventually lead to a sharp correction/bear market that could generate a massive flight to quality towards Treasuries. Fourth, corporate bonds are also trading splendidly and represent a less attractive alternative than in the past. Lastly, it is not just U.S. Treasuries that might represent good value: options on U.S. Treasuries are trading near historic lows and could also be in for a bull market if volatility increases.
The U.S. Federal Reserve (Fed) is finally ready to shrink its balance sheet gradually. For a little perspective, back in the days before the 2008 financial panic and the subsequent introduction of Fed asset purchases, known as Quantitative Easing or QE, the Fed’s balance sheet was about 6% of GDP, or less than a trillion dollars back in 2007. As of June 2017, the Fed’s balance sheet has swollen to almost 25% of GDP or $4.5 trillion dollars.
Over the past four decades, the Australian dollar (AUD) has traded in a range versus the U.S. dollar (USD) from 0.48 to 1.20 (Figure 1). After spending most of the period from 2011-2013 above parity, AUD has returned towards the middle of its historic range, having fallen as much as 38% from its recent highs. Given how much it declined between early 2013 and the end of 2015, it is tempting, but possibly wrong, to conclude that AUD’s bear market might be over. Given Australia’s dependence on the export of raw materials to China and the country’s rising debt burden, we wonder if AUD risks retesting its lows of around 0.5 AUD per dollar this decade.
British Prime Minister Theresa May was dealt a severe blow in the snap election she called to strengthen her hand. Will her coalition be strong and stable?