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The Conundrum Facing Treasury Investors

3 October 2019 by Mark Holman

One of the most frequent discussions we have on the desk at TwentyFour is around how much protection we need.

With global economic data steadily deteriorating, we know we need to be appropriately cautious, and within the ‘risk free’ universe of negatively correlated fixed income assets we have recently preferred US Treasuries to do the job.

So the discussion quickly moves to how much duration we need in this protective bucket of ‘risk free’ assets. The answer to this question will of course be specific to any particular portfolio, but all bond investors are faced with the same difficult decision right now.

Treasuries and other ‘risk free’ assets have enjoyed a very powerful rally that dates back almost a year, and they have moved to levels that are already beyond what we might expect to see amid a global economic slowdown. On the face of it that makes sense; many investors will have taken a weakening global economy and the world’s major central banks moving back to easing as a green light for taking on additional rates risk.

However, the single biggest influence on the rally has been the global trade war, and here we move into the realm of the unpredictable.

Talks between the US and China have been on and broken off several times. As of now they are back on, with talks slated for October 10 in Washington, but will they break the deadlock this time?

For us there is no doubt that if talks move forward, Treasury yields will jump. Only last week President Trump hinted that a trade deal could be much closer than people think, and in the space of minutes the market had added 10 basis points to the 10-year UST yield. Yields could quite easily back up towards 2% if next week’s discussions move in the right direction.

On the flip side, should there be a breakdown, we know how long it takes to get the parties back together again, and we also know that the trade tensions are hurting supply chains, creating business uncertainty and causing a meaningful pullback in business investment. With no breakthrough, the data is only likely to deteriorate further and UST yields could test their all-time lows again.

The one thing we are sure of is that US Treasuries and all other risk free rates products will be volatile, one way or the other. It is easy to say these are liquid instruments and investors should be able to trade through the volatility. To some extent this is true; we like other bond investors can and do try to trade the ranges, but investors in this sector know this is difficult to do on a consistent basis.

So to return to the original question, how much protection do we need? It’s an almost daily debate. We think the best approach has been to maintain a core and significant strategic allocation to ‘risk free’ assets as the data has dictated being more cautious, regardless of the fact that risk assets have virtually turned a blind eye to the deterioration.

We think the downside to markets is still underappreciated, and thus we would prefer to stay long protection. However, acknowledging the volatility, a smaller tactical overlay would allow us to put our more short term thoughts to work without compromising the strategic need to be biased for caution.

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