The U.S. Treasury bond market has adjusted to the potential for a March Federal Reserve (Fed) rate hike, with shorter maturity yields moving substantially higher, and thus lower in price, from Tuesday’s (February 28, 2017) close. For investors who are reluctant to buy longer, riskier bonds, perhaps the shorter-duration, liquid U.S. Treasuries might represent an opportunity at current levels.
On Wednesday, the 2-year Treasury yield moved to 1.30%, its highest yield since 2009 (see below chart). This is well above the 0.56% average yield since 2009. These AAA-rated bonds are backed by the full faith and credit of the U.S. government. Generally, as the Fed hikes rates, the shorter-maturity part of the yield curve tends to adjust more dramatically in price, and so investors should determine whether the recent price adjustment already factors this in. Keep in mind that the 2-year bond is 58% higher in yield (moving from 0.82% to 1.30%) from November 7, 2016 (pre-U.S. election) to today. Some would argue that the Fed move has been largely priced into the market already. It is difficult to determine this for a fact, although when comparing the U.S. yield to foreign bonds, the case is compelling.
With the European Central Bank (ECB) continuing its bond-buying program, many European government bond yields are pricing at negative levels, making the U.S. Treasury cheaper on a relative value basis. This is evident when comparing German, Spanish, and French 2-year yields against the 2-year Treasury. In addition, the credit rating differentials are compelling. According to Moody’s, the Spanish credit rating is Baa2, well below the U.S. bond’s AAA Fitch rating, the highest credit quality. However, currently investors can buy the lower risk U.S. bond at a 1.30% yield, versus -0.12% for the Spanish bond, thus picking up 142 basis points (1.42%) of additional yield and a higher credit quality bond. The typical assumption is that lower quality bonds must trade at a higher yield to compensate investors for the greater risk, but this is not the case for many European government bonds. The German 2-year bond, a bond comparable in quality to Treasuries, is yielding -0.84% (as of March 1, 2016) and recently priced at a historic low of -0.95%. This puts the spread versus the U.S. 2-year at 214 basis point advantage. In addition, the French 2-year is yielding -0.52% (as of March 1, 2017), a 182 basis point spread to the U.S. bond. With the exception of Germany, these bonds are lower quality than U.S. Treasuries.
While the 1.30% 2-year Treasury yield can go higher, other global bond yields are very low and should eventually increase. Until this time, Treasuries may benefit from foreign buying in the near term, helping to keep Treasury yields lower than they would otherwise be due to the yield differentials outlined here. However, this may take some time as global central banks continue to provide liquidity for the near term, with the ECB not scheduled to reduce its quantitative easing program until the end of 2017.