US Treasuries, Another Fork in the Road

US interest rates took a turn higher yesterday after falling most of last week and may continue climbing higher on Monday with fears of stronger US economic data reports in the days ahead. The 10 year note may very well hit 3% by the end of June unless some unforeseen and unlikely risk squall hits our shores in the months ahead. Yields have been trending higher since last month as the monthly US Treasury refunding buried traders in bonds just as anxiety over the European debt crisis was waning and US economic data had been mostly signalling a stronger than expected economic recovery. Unseasonably warm weather during winter has likely played havoc with US economic data that is almost all seasonally adjusted, possibly giving the appearance that the economic recovery is more brisk than common sense might suggest from those of us who actually live here. More importantly though, most would agree that 10 year notes do not belong and probably never did belong at 2% or lower and that unnatural state was, and still is caused by the Federal Reserve's "Operation Twist" program whereby the government is buying back Treasuries with maturities 7 years and longer. That program is ending in June, so as long as market sentiment remains "risk on", Treasury yields are susceptible to moving higher, especially around big bouts of supply like we will see in the second week of every month. Inflation is running at least 2% so after taxes US Treasuries provide negative real yields and the only justification for holding them would be risk aversion. Europe's successful implementation of the LTROs, lending European banks 1 trillion Euros of 3 year money at 1%, as well as the successful restructuring of Greek debt substantially reduced people's risk aversion for the moment. US equities have had their best 1st quarter return on record and high yield returns continued to reward investors for taking credit risk. The relatively low yielding Treasury has been one of the best returning asset classes of the past 20 years but is likely to become a drag on investor portfolio returns in the coming years so get out of the way. We are often reminded that the Federal Reserve Chairman is a student of the Great Depression, and he takes every opportunity to make dire pronouncements about our economy and fiscal state to justify extremely accommodating monetary policy. One hopes he has studied equally as much the stagflation of the 70s as well as how difficult and how long it took to reduce inflation in the US to current levels as our economy has an inherent inflation bias built into it already. When the Fed does eventually decide to reign in the money supply, people will be reminded of just how volatile short maturity interest rates can be but that is still at least a year away. What is more imminent is the threat of rising long term interest rates as the US and European economies progress toward a more normalized state from the state of emergency that currently exists.