A nation’s government has a demand for cash to finance public investments, defense, public social programs and other recurring services. Typically, a government sources these funds through tax revenues from its citizens and foreigners or companies doing business within the country’s borders. However, it is often the case that tax revenues do not fully cover government spending resulting in a fiscal deficit. In the case of a fiscal deficit, governments need to borrow primarily through the issuance of debt securities or from taking out loans from other countries and multilateral organizations like the International Monetary Fund. The United States is the largest economy in the world and has generally operated in a fiscal deficit since 1970. In recent years this amount has been over US$1 trillion per year. To finance this deficit, the United States Government issues Treasury Securities, which today are primarily held by the United States Federal Reserve, institutional investors and governments of other countries such as China and Japan. Owning US Treasury Securities makes the holder a creditor to the US government.
What are these Treasury Securities?
Treasury Securities are grouped into three broad categories:
- T-Bills: These securities have the shortest maturities of US government bonds. T-bills mature in
four, eight, thirteen, twenty-six or fifty-two weeks. These are issued at a discount and mature at par
- T-Notes: Treasuries with maturities of 2 to 10 years are called T-Notes. These are issued at par and
pay interest coupons semiannually.
- T-Bonds: Identical in issuance and coupon terms to T-Notes, T-Bonds mature in 30 years.
Treasury Securities are grouped into three broad categories:
The market for Treasury Securities is among the most liquid in the world with an average daily volume of US$627 billion in September 2022. Treasuries are unconditionally backed by the full faith and credit of the United States government and are issued in US dollars, the world’s reserve currency. As a result, Treasuries are considered the safest investment in the global financial markets. Financial analysts often rely on treasury yields as a proxy for the “risk-free rate” when pricing securities in other markets due to the guarantee by the US government.
What Inferences can be made from Treasury Securities?
The prices and yields of US treasuries fluctuate similarly to other debt securities. They are influenced by central bank interest rates, macroeconomic conditions and overall supply and demand dynamics for the instruments. These fluctuations in prices also depend on the time to maturity of the security. The US Treasury yield curve plots treasury interest rates over a range of maturities. A normal yield curve slopes upwards with interest rates increasing as the time to maturity increases. This reflects the
higher price risk and opportunity cost associated with longer-dated bonds resulting in investors demanding higher yields. A normal yield curve indicates financial markets are healthy and a smooth increase in yields with increasing maturities suggests stable economic conditions. As economic conditions slow, the slope of the yield curve may become less steep and may eventually
become inverted. An inverted yield curve happens when shorter-dated bonds have higher yields than longer-dated bonds. This means investors’ preference for longer maturity bonds has increased relative to near-term maturities, indicating that the market is pessimistic about short-term economic prospects and anticipates greater near-term risk. The returns on longer-term investments are acceptable to investors who anticipate a falling equities market. Additionally, in the event of a recession, long-dated treasuries have the potential for greater price appreciation as interest rates are cut to encourage economic activity. Historically this phenomenon has been exemplified by the strong tendency for a higher 2-year treasury rate than the 10-year rate to precede a recession. The current yield curve indicates this inversion is very deep when compared to past inversions. This deep inversion corresponds with the consensus expectation of the likelihood of a recession in the next 12-18 months at nearly 100%.
What does this mean for consumers and retail investors?
In addition to the yield curve inversion signalling volatile economic conditions in the near term, the 2- year treasury yield near 4.5% is at the highest level recorded since 2007. The elevated interest rate environment is also reflected across the market for consumer credit, including car loans, mortgages, credit cards and lines of credit as the cost of funds among institutional providers of credit has trended in a similar fashion. As such, a greater portion of household income will go towards servicing debt. Higher interest rates on US government debt puts downward pressure on the pricing of corporate bonds and equities as investors can now earn a higher return on less risky treasury investments. As such, given that the expected return on the lowest-risk securities in the market has increased (implying lower prices), so too will the expected return on higher-risk securities as investors demand a higher return for higher risk.
The yields offered on US Treasuries at different maturities are important data points for investors in assessing market sentiment regarding future economic conditions and ultimately, appropriate portfolio positioning. US treasuries are currently indicating challenging times ahead. Strategies that prioritize capital preservation methods may be prudent in minimizing portfolio drawdowns in that market conditions worsen materially. Larger cash positions can help in servicing the higher cost of debt and can also be used to take advantage of opportunities that arise from falling asset prices. Additionally, a larger allocation to consumer staples, healthcare and other defensive sectors is appropriate given the current economic backdrop as these sectors tend to be less impacted than more cyclically dependent sectors such as consumer discretionary and industrials.
Written by Michael Pryce
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