Why betting on higher Treasury yields in 2010 may prove dangerous

January 10, 2010 - 0:0

There's a laundry list of reasons longer-dated Treasury yields should keep rising: increased government borrowing, concerns the Federal Reserve's easy monetary policy will stoke inflation and investor preference for higher-yielding alternatives.

So the 10-year Treasury yield has been on a forced march higher while the shorter-dated two-year has meandered, making for a record difference, or spread, between the two.  
This is welcome news for banks trying to earn their way out of the sub-prime mess. It allows them to borrow cheaply in short-term markets while investing in higher-yielding assets that mature over a longer-term horizon.
That's easy money. The Fed's insistence that it will keep its overnight interest rate near zero percent for an “extended period” makes positioning for a steeper curve seem like a smart bet. The two-year note isn't likely to budge much until that phrase changes.
But there are plenty of factors that could upset the balance without the Fed lifting a finger. First, the economic recovery isn't all that. Already, third-quarter GDP has disappointed at just 2.2 percent, down from the originally reported 3.5 percent. And with another terrible year for the labor market on the cards, workers won't have much leverage to demand higher wages. That could keep a lid on already-low inflation.
Then there's the shortage of AAA-rated debt securities that investors who like to sleep at night crave. The credit crisis got rid of the competition from the structured products arena.
There are far fewer ultra-safe bonds backed by consumer debt or corporate bonds to choose from.
So the temptation to buy longer-dated Treasuries that have more juice than shorter-dated ones may contribute to depressing yields. Of course, a good growth spurt with a modicum of inflation -- which smart investors ranging from John Paulson to Julian Robertson seem to be betting on -- would probably be sufficient to offset these supply-driven issues.
But they'd be wise to recall there is some precedent for yields moving in ways the market least anticipates.
Indeed, when the Fed raised rates in 2004, the yield on the 10-year Treasury note fell despite expectations to the contrary.
Fed chairman Alan Greenspan labeled the event a conundrum. Investors who got burned the last time around can't say they haven't been warned.
(Source: Daily telegraph)