Author: Amanda Ahne
Asset Allocation Bi-Weekly – Who Wants US Treasurys? (February 20, 2024)
by the Asset Allocation Committee | PDF
Before August 2023, the Treasury’s quarterly refunding rarely raised eyebrows. Investors readily snapped up US debt, and announcements were largely ignored by markets. However, Fitch Ratings’ surprise downgrade of the US credit rating from AAA to AA that month, just days after a $6 billion increase in the planned quarterly debt issuance, sparked investor concerns. Now, the question looms: Will there be enough demand to absorb the growing supply of US debt?
The downgrade by Fitch triggered a sharp rise in Treasury yields, especially long-term yields, which hit their highest levels since 2007. The 10-year and 30-year benchmarks spiked to multi-decade highs, reflecting lukewarm participation at Treasury auctions. Higher borrowing costs and weak auction participation sent the S&P 500 Index tumbling. In response to the market’s negative reaction, the Federal Reserve signaled an end to its hiking cycle and a potential cut in policy rates for the coming year, and the Treasury Department tilted its borrowing toward shorter-term maturities.
While the coordinated efforts of the Fed and Treasury successfully reduced borrowing costs and improved overall risk appetites, investors remained uncertain about the government’s plans to finance its burgeoning debt. This year, $8.9 billion of US Treasury bonds will mature, while the budget deficit is expected to be $1.4 trillion, meaning there will be $10 trillion of bonds coming to the market. Additionally, the Congressional Budget Office projects that the deficit could expand to $2.6 trillion by 2025. This leaves a gaping hole in financing, and without a significant change in market conditions, it is unclear who will step up to buy these bonds.
The US Treasury market boasts a unique blend of buyers, each with distinct goals. Central banks, the guardians of global monetary systems, buy Treasurys to secure their reserves and stabilize currencies. Similarly, pension funds prioritize stable, long-term income to fulfill their liability obligations. For the Fed, Treasurys become instruments of monetary policy, influencing interest rates and economic activity. Asset managers diversify their portfolios with these secure assets, reducing risk and volatility. Even households directly participate in holding a portion of the national debt, seeking a safe place for their investments.
The Fed’s shift toward tighter monetary policy in 2022 and 2023 reshaped the allocation of Treasurys. By not rolling over its maturing Treasury holdings, the Fed is now absorbing less of any new supply. Simultaneously, interest rate hikes have incentivized some corporations and foreign central banks to moderate their holdings, creating a demand gap. Households, pension funds, and insurance companies have stepped in to fill this gap, becoming the primary buyers of Treasurys. However, the central bank’s recent suggestion that it will phase in monetary easing later this year introduces uncertainty about who will buy debt going forward.
The high concentration of interest-sensitive investors like households, pension funds, and insurance companies in the bond market raises concerns about the potential impact of future interest rate cuts. Lower short-term rates typically decrease the appeal of risk-free assets like long-term bonds, potentially dampening demand. Households seeking higher returns in an accommodative monetary policy environment may consider diversifying into riskier assets. However, while pensions and insurance companies hold a significant portion of Treasurys, their demand for longer-term bonds is limited by their need to match their obligations.
Historically, broker-dealers have played a key role in stabilizing markets by absorbing available assets, but they face constraints that limit their ability to act as the buyer of last resort when the Fed doesn’t step in and provide liquidity. Broker-dealers, unlike central banks, hold limited inventory as they are primarily focused on facilitating client transactions rather than large-scale asset purchases. This limited capacity restricts their ability to absorb significant volumes of assets during periods of stress. To compensate for the inherent liquidity risk involved in holding large inventories, broker-dealers would require higher premiums, therefore pushing up yields on Treasurys.
With limited demand from traditional buyers putting pressure on long-term Treasury yields, concerns have risen that the Fed may need to intervene to prevent higher borrowing costs for businesses and consumers. Yet, policymakers remain reluctant to increase the balance sheet due to inflation concerns. Chair Powell reiterated during the January FOMC press conference that the committee will discuss slowing QT at their March meeting, suggesting that the committee is not ready to stop reducing its balance sheet.
While potential rate cuts and future reductions could increase demand for Treasurys, limited impact on yields is expected due to persistent inflation concerns and lukewarm investor sentiment. Given the continued supply-demand imbalance, we believe short-to-intermediate-term securities offer a more attractive risk-reward profile compared to long-duration bonds due to their lower interest rate sensitivity and potentially higher returns.
Back to the Future: The Advantages of Dividend Income Over Interest Income (February 2024)
Insights from the Value Equities Investment Committee | PDF
Over the past 15 years, dividend income has often exceeded what could be earned in a money market account. But as seen in the chart below, with the fed funds rate now at 5.5%, the relationship between dividend income and interest income has gone back to what was common before 2008 — where the S&P 500 dividend yield (the blue line) is 2-3% below what could be earned in a money market account invested in U.S. Treasury bills (the red line).
This begs the question:
Why should an income-oriented client still invest in a dividend income-focused stock portfolio yielding 3% when they can now earn 5% in a low-risk money market account?
Higher inflation is causing interest rates to rise on short-term fixed income and money market instruments, and now investors have more choices in generating income returns. While current yields are appealing, we believe it would be short-sighted for long-term investors to abandon the compounding benefits of a growing income stream that can protect purchasing power while also providing for growth of principal.
In this Value Equity Insights report, we highlight some of the potential advantages of growing dividend income through a portfolio of quality, growing businesses — factors which might be underappreciated in the current environment.
Confluence of Ideas – #35 “Reviewing the Asset Allocation Rebalance: Q1 2024” (Posted 2/13/24)
Bi-Weekly Geopolitical Podcast – #41 “Thinking About Deterrence” (Posted 2/12/24)
Bi-Weekly Geopolitical Report – Thinking About Deterrence (February 12, 2024)
by Patrick Fearon-Hernandez, CFA, and Daniel Ortwerth, CFA | PDF
In his book Leviathan, published in 1651, the English philosopher Thomas Hobbs argued that human society in the state of nature would be marked by conflict and mistrust, as each person would be free to attack his or her neighbor to acquire needed resources. According to Hobbs, government evolved to end this chaotic, violent state by providing security and order to society. Without a powerful central government, Hobbs posited, life would be “solitary, poor, nasty, brutish, and short.”
But what about the community of nations, where each country could be tempted to attack its neighbor for political, economic, or other reasons? No world government has evolved to provide order and security in international relations, even if the UN has been given some powers aimed at helping it keep the peace. As we’ve written before, the more typical source of international security and order has been when a powerful country gained hegemony over much of the globe, as the United States did in the decades after World War II. As US voters now question the costs and benefits of that hegemony, and as the US hesitates to enforce order, rival countries have begun to assert themselves. “The Jungle Grows Back” is the term we use to describe the situation. This report examines how, in this newly chaotic world with weakened hegemonic order, nations may increasingly rely on “deterrence” to protect themselves, with potentially big implications for investors.
Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify | Google
Asset Allocation Bi-Weekly – #113 “U.S Oil Production at a Record High” (Posted 2/5/24)
Asset Allocation Bi-Weekly – U.S. Oil Production at a Record High (February 5, 2024)
by the Asset Allocation Committee | PDF
These days, because investors have so many different assets to buy in so many different financial markets, it can be easy to miss an important trend or change in trend. Indeed, that seems to be the case with crude oil, where the long stagnation in U.S. output after the COVID-19 pandemic has suddenly turned into a new surge. In fact, U.S. oil production has recently reached a new record high. In this report, we explore what allowed domestic output to start expanding again, what it means for the global economy, and the potential implications for investors.
As shown in the chart below, U.S. field production has fluctuated quite a bit over the last century. From 1920 to 1970, output grew approximately 4.2% per year, reaching 9.6 million barrels per day (bpd). However, output then fell and plateaued, despite the incentives to produce during the period’s high prices. Beginning in about 1985, production began what appeared to be an inexorable decline in the face of public policy and the limits of the available technology. To many people’s surprise, output suddenly reversed and started growing rapidly again during the Great Financial Crisis of 2008-2009, driven by new technologies such as hydraulic fracturing and horizontal drilling that opened up previously untappable shale formations. U.S. production jumped at an annual rate of 8.7% from 2009 to 2019, reaching almost 13.0 million bpd.
Obviously, the pandemic was a shock to the global economy. With the collapse in demand, oil prices actually turned negative for a short time in early 2020. More importantly, U.S. output fell sharply and appeared to stagnate. Much of the stagnation reflected reduced investment in new exploration and development as investors demanded better capital discipline and a stronger focus on profitability after the many bankruptcies of shale drillers during the period of 2009-2019. Stronger environmental regulations, which aimed to shift the economy away from fossil fuels, also discouraged drilling. Many investors began to question whether the industry could ever grow again.
In mid-2023, U.S. oil output began to accelerate in earnest, likely reflecting the incentive of high energy prices at the time and an unexpected second wind from technology improvements. Press reports say fracking and other shale technologies as well as operating approaches have simply improved more than expected. In any case, U.S. oil output has now reached 13.3 million bpd.
For the global economy, booming U.S. oil output doesn’t just mean that the country has become the world’s largest producer (which it has). As shown in the chart below, it also means that the U.S. has been able to significantly scale back its imports of foreign oil.
Surging U.S. oil production has altered global pricing dynamics. For example, before the shale boom, U.S. domestic oil prices (represented by the West Texas Intermediate) were typically slightly higher than foreign prices (represented by Brent Crude). For the last decade, however, the rich supply of domestic oil has held down U.S. prices. Reduced U.S. import demand and new laws allowing U.S. oil exports have also improved supplies for other countries. As shown in the following chart, Brent Crude now tends to trade several dollars higher than WTI. Nevertheless, the U.S. changes haven’t been enough to totally offset the fact that Saudi Arabia and its partners in OPEC and OPEC+ are withholding supplies in order to boost prices.
Going forward, the unexpected rebound of U.S. oil output and exports signifies that American production could help keep a lid on global prices for an extended period, even as the OPEC+ countries continue to withhold barrels. What could change the outlook? One key risk that we’re focused on is the possibility of a geopolitical crisis that disrupts supplies from a major foreign producer or exporter. If such a crisis occurs outside the Middle East, the availability of excess output capacity in Saudi Arabia and the rest of OPEC+ could potentially fill in the gap. If the crisis disrupts Middle Eastern supplies, however, the result would likely be a spike in global prices despite the renewed U.S. output boom and excess production capacity in the region.