The Brexit vote in favor of ending the United Kingdom’s membership in the European Union effectively took Federal Reserve interest rate increase off the table for July, and September, and November. And maybe even December. Remember that the process of exiting the European Union is a long one–and the two-year deadline for a departure doesn’t even get started until a U.K. government asks for an exit. We could still be in the scary, early, nobody knows what’s happening stages of an exit come December. (This post originally appeared on my subscription site JubakAM.com on Saturday June 25.)
And if a Federal Reserve interest rate increase is off the table for that long and global financial markets remain unsettled for that long and growth in the global and U.S. economy is going to be lower than projected just a month or so ago, I think it’s time to rethink exactly how low yields on the 10-year U.S Treasury can go.
The logic here is pretty simple. In an uncertain financial market investors and traders look for safety in assets such as Japanese government bonds, German bunds, and U.S. Treasuries.
As long as the threat of a Federal Reserve interest rate increase was a real danger, putting cash into Japanese government bonds and German bunds had a certain attractiveness over buying U.S. Treasuries. A hike in U.S. interest rates could send the price of existing Treasuries lower. The end of that threat from the Fed for the months ahead removes that disadvantage.
And that allows the big yield advantage of U.S. Treasuries to come to the fore. The yield on a ten-year U.S. Treasury was 1.56% as Friday, June 24. That compares to a negative 0.17% yield on the 10-year German bund and a negative 0.185% yield on the 10-year Japanese government bond.
If you are looking for safety and would actually like to make a little bit of money while you sit on near-cash, what do you think is more attractive right now? Collecting 1.56% in U.S. Treasuries or paying 0.17% or 0.185% to hold German or Japanese government bonds, respectively.
Which is why bond managers are forecasting a new drop in yields for U.S. Treasuries in the months ahead. Do remember that a drop in yield works out to an increase in the price of Treasuries.
The consensus among these Treasury bulls is that the yield on 10-year Treasuries is likely to drop to something like the 1.38% historic low of July 2012 or even further to a new historic low near 1.25%.
What would a drop to 1.38% or 1.25% from today’s 1.56% yield mean to bond prices–and the gains that bond buyers can think about?
If the yields on 10-year Treasuries fall to 1.38%, the price of a $1,000 Treasury bond would rise to $1130.44 for appreciation of 13.4%.
If the 10-year Treasury yield falls to 1.25%, the gain would be 24.8%.
Mind you I wouldn’t count on Treasury yields falling to match the historic low or to bust through that low to 1.25%. But it won’t take a drop all the way to those levels to make this a profitable position, especially when the U.S. and global economy look weak enough to keep returns from equities to very low levels.
You can, of course, buy Treasuries directly in the market or from the U.S. Treasury itself. And there’s no reason not to–the process is very easy. Or you can make it even simpler for a very modest fee by buying an ETF such as the iShares 7 to 10 year Treasury Bond ETF (IEF.) The expense ratio is a low 0.15%. For the year to date total return on this ETF is 7.06%, which certainly beats the 0.32% return for the Standard & Poor’s 500 stock index. Currently the ETF yields 1.58% and it pays dividends monthly.
I’m going to add this ETF to my Jubak Picks 12-18 month portfolio on Monday, June 27.