A compelling case for carry in Treasuries

September 11, 2009

Under normal circumstances, U.S. Treasuries should probably be getting clobbered.

The worst of the credit crisis is over, the economy is expected to snap back in the second half of the year, and the appetite for riskier, higher-yielding assets should be siphoning off demand from boring, safe-haven assets like Treasuries.

But things haven’t been normal for a while.

Treasury yields are down substantially from three months ago. This week provided additional evidence that something is not quite right. The government dumped $70 billion of three-year, 10-year and 30-year Treasuries into the market, yet yields fell.

But when you consider how much banks and other investors who enjoy dabbling in leverage can make by deploying that oldie, yet goodie, “the carry trade,” the recent rally in Treasuries doesn’t seem so crazy.

The carry trade in its simplest form is a way for investors to make money by borrowing at short-term low rates and investing in securities that yield much more.

Right now, short-term funding costs are at rock bottom rates — the overnight federal funds rate is sitting around 0.15 percentage point and three-month London interbank offered rate at just 0.3 percentage point. The 10-year benchmark Treasury note yields 3.33 percent and the 30-year bond, 4.16 percent.

So, in very simplistic back of the envelope terms, investors can earn more than three percentage points simply by borrowing short and investing in longer-dated securities.

The inherent risk, as many learned painfully during the credit crisis, is if the funding suddenly becomes much more expensive, or worse, vanishes.

But there seems little chance of that happening, given the expectation that the Federal Reserve will keep short-term interest rates extraordinarily low, possibly into 2011, for fear of derailing the emerging economic recovery.

Moreover, inflation, which erodes the value of bonds, shouldn’t become a serious problem until the labor market recovers and employees start demanding higher wages.

Big banks still nursing their balance sheets back to health would be a prime candidate for such a trade. They can earn easy money while adding risk-free Treasuries rather than riskier assets that would tie up precious capital.

It’s also compelling when they’re not doing very much new lending, notes David Ader, head of government strategy at CRT Capital Group, who uses this chart to make the point.


The fact that the Federal Reserve is buying up great chunks of the agency mortgage-backed securities market also drives demand toward Treasuries, since there’s a scarcity of higher-yielding, longer-dated securities out there.

This of course could set the markets up for a painful adjustment when the outlook on Fed policy and inflation changes, but for the time being it’s likely to keep a lid on rising Treasury yields for no other reason than it’s hard to say no to easy money.

It could also send confusing signals to those looking to markets for clues about where the economy is heading, especially when stocks and bonds are heading up at the same time.

But then again, things aren’t likely to return to normal until the emergency stimulus is finally drained from the system.

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