Tags: Allure of Risky Assets Are Bonds Biggest Hurdle in 2011

Allure of Risky Assets Are Bonds' Biggest Hurdle in 2011

Friday, 31 Dec 2010 02:26 PM

U.S. Treasurys may struggle to replicate this year's relatively strong returns in 2011 if the economy grows as much as some expect, as riskier assets could continue to outperform the government debt.

Government debt may be poised to see a strong first quarter, however, after a dramatic rise in yields since November, if economic indicators disappoint or eurozone problems again attract market focus.

U.S. government bonds returned 5.33 percent for the year, the best performance since 2008, according to data by Bank of America Merrill Lynch. Much of the earlier gain was pared late in the year, however, with losses of 2 percent in December alone.

Returns also significantly lagged riskier assets including commodities, stocks and corporate debt.

"Commodities beat out everything," said Brian Yelvington, analyst at Knight Capital Group in Greenwich, Connecticut. "I wonder if that is indicative of us getting commodity price inflation versus the good kind of inflation that the Fed wants to engineer involving employment and wage pricing."

Treasurys lagged as investors priced in higher inflation and growth expectations when the Federal Reserve announced in early November it would buy $600 billion in bonds in its second round of quantitative easing.
The program is designed to ward off deflation and has helped encourage investment in riskier assets.

High yield corporate bonds returned 15 percent on the year while investment grade bonds yielded 9 percent and stock markets rose more than 10 percent.

Commodities prices surged across almost every class, led by an 83 percent increase in cotton and 82 percent jump in silver. Gold returned 30 percent.

New tax cuts and tax extensions also caused investors to reprice government debt in thin trading conditions in December as investors anticipated higher growth but also focused on the rising debt burden of the U.S. government.

Benchmark 10-year note yields on Friday were on track for the biggest rise since December 2009, increasing to 3.32 percent, from 2.80 percent at the beginning of the month.

As traders return to their desks next month, they will be looking to see if new data backs up their more bullish economic projections.

"The sell-off over the last couple of months has happened on the expectation of future inflation. However, this seems too preliminary given the data that's come out over the past few months," said Yelvington.

Disappointing releases could send yields lower, while euro zone concerns could again spark a safe-haven bid for Treasurys.

"I think the big focus for the first quarter will be what's going on in Europe. People are beginning to get more of a sense about the problems that they face," Yelvington said. "In the short end we will definitely see a return to the tights, in the back end it remains to be seen if people continue to price in those inflation expectations."

A credit default swap index on European sovereign debt ended the year at a record high Friday, illustrating continuing concerns over problems in the region.

Meanwhile the expiry of the Fed's bond purchase program in the middle of the year will remove a large support to the market, if it is not extended, which could send yields higher.

"With QE2 ending in June, it is probably going to be some time in March that people are going to be anticipating that as the first phase of monetary tightening," said William Larkin, fixed income portfolio manager at Cabot Money Management in Salem, Massachusetts.

"Taking that big buying scheme out of the system could really hinder Treasurys, and we don't know how high yields could go — we could see a pop up to 3.75 percent" for 10-year yields," Larkin said.

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