With the US economy continuing to grow – giving the Federal Reserve confidence to withdraw the stimulative measures brought in after the financial crisis – some managers are beginning to question whether it is time to snap up US Treasuries.
The US economy has now entered its eighth year of economic expansion having recorded GDP growth of more than 3 per cent in two of the past three quarters, said Paul Causer, Invesco Perpetual’s co-head of fixed interest.
The recent tax cuts package announced by US president Donald Trump and other measures from the recent budget could add a further 1.3 percentage points to US GDP over the next two years.
“One has to go back to the Regan administration of the 1980s to see another time when such a pro-cyclical fiscal policy was pursued,” Causer explained.
This strong economic backdrop comes at a time when the US output gap is estimated to have closed for the first time since the financial crisis and could potentially signal that inflation will continue rising.
“Very recent core inflation has been noticeably higher and with unfavourable base effects and the weaker dollar, there is some chance that core inflation reaches 2 per cent even before any additional price rises emerge,” he added.
5yr-5yr forward inflation expectation rate
Source: Federal Reserve Bank of St. Louis
While the Federal Reserve has previously signalled its intention to raise interest rates three times this year, some market watchers are now speculating that early signs of rising inflation could prompt new chair Jerome Powell to raise rates four times in 2018.
Indeed, on Wednesday night the Fed raised rates by 0.25 percentage points taking them to a range of 1.5-1.75 per cent, with forecasts becoming more hawkish.
Nitesh Shah, director at ETF Securities, suggested that it would not take much prodding for the central bank to hike a fourth time either.
“Looking at the ‘dot-plots’ – the FOMC [Federal Open Market Committee] participants own estimate of where rates will end the year – they appear to be split between three or four hikes for this year, but given how few members expect anything less than three, it will only take a continuation of good economic data to nudge the committee to four hikes for the year,” said Shah.
This would represent quite a pick-up in pace as the Fed has only raised rates four times since December 2016 – when it embarked on its rate-hiking program. It has also begun to reduce the size of its balance sheet after years of unprecedented quantitative easing (QE) measures.
“Such a strong backdrop would suggest that US duration risk is unlikely to be appealing until yields are back towards their pre-financial crisis range of 4-4.5 per cent,” said Causer (pictured). 
“However, whilst we believe that US government bonds are in a managed bear market, there are reasons why they could become attractive before they reach their pre-crisis levels of yield.”
First is that while the US (and most of the rest of the world) is in the midst of the strongest cyclical upturn since the global financial crisis and there is no strong evidence that consumer prices are heading back to pre-crisis levels.
Indeed, the core personal consumption expenditure deflator – which tracks individual consumption – is only growing at 1.5 per cent, below the Fed’s inflation target of close to 2 per cent and noticeably below the rate of the mid-2000s.
Secondly, US wage inflation is still subdued, said Causer, with the Employment Cost index “significantly below the pace of growth it showed before the financial crisis”.
“Thirdly, productivity has been very low over the past decade and any recovery in capital investment – of which there is some evidence recently – could lead to higher productivity and extend this period of non-inflationary growth,” he added.
“The seismic changes brought about by the rise of the internet economy could continue to keep inflationary pressures modest.”
Finally, levels of indebtedness remain elevated with US debt around 250 per cent of GDP despite the deleveraging of the financial sector, implying fewer rate rises will be undertaken.
As such, US monetary policy and government bonds are already adjusting, with the US interest rate potentially as high as 2.25-2.5 per cent by year end – its highest level for 10 years. Meanwhile, US two-year yields are already at 10-year highs and the 10-year yields are at 5-6 year highs, having risen from 1.3 per cent in mid-2016.
Overall, while the US economic backdrop and outlook are strong and US government bond yields will likely need to continue their process of adjustment, there are a number of reasons to believe that the rate hiking cycle this time may be more modest than it has been in the past, Causer said.
“Inflationary pressures are well contained and by the end of the year we will have already had two percentage points of tightening,” the Invesco manager added.
“If we get to the stage where we believe that a sufficient readjustment has been made, we will be in a position to increase our duration risk accordingly.”
As such, Causer said his starting point for US Treasuries is “very defensive.”.
However, one manager that has already upped his exposure to US Treasuries is FE Alpha Manager Steven Andrew, who heads up the £805m M&G Episode Income fund.
“The fund has always had a position in long-dated US Treasuries, apart from February to August 2012 when the yield had become deeply unattractive, since they are useful in terms of portfolio construction for their diversification purposes and as ‘insurance’, in the event of any significant sell-off in equity markets,” he explained.
Performance of fund vs sector since launch
Source: FE Analytics
“Although we feel that, in general, there is little value in most mainstream government bonds and so have no exposure to German bunds, French OATS, UK gilts or Japanese government bonds, we have built up a fairly large weighting in US Treasuries over recent months, using bouts of price weakness to boost the holdings.
“These bonds are held as insurance against a major drop in equity prices and as a diversifier to some of the fund’s emerging market bonds.”
US government bonds in particular have become more attractive in recent months with the yield on the 10-year Treasuries moving to around 2.8 per cent.
Yet while the yields on US government bonds could still rise if, for example, economic expansion continues at a steady, rather than breakneck, pace, it should be of benefit to the equities portion of his portfolio which makes up around 47 per cent of the fund.
“If, however, the economy performs in a different manner, then the Treasuries held in the portfolio should provide good quality diversification while delivering a decent level of yield,” he said.
“As the yield on 30-year US government bonds has risen towards 3.5 per cent, we expect the bonds’ potential diversification properties to improve further, although the yield remains some way off the level last seen towards the end of the ‘taper tantrum’ in 2013.
“On the other hand, 10-year Treasuries have performed worse than 30-year bonds and their yield has now reached ‘taper tantrum’ levels at around 3 per cent.”
This, he said, was a reasonable return and explains the recent 3 per cent weighting in the fund of 10-year US Treasuries.
“This position should broaden the fund’s fixed income exposure and add to the potential diversification of the portfolio,” Andrew said.