Continued weak results on the employment front from the Bureau of Labor Statistics jibes with all sorts of other weak coincidental and forward-looking data. The ECRI's Weekly Leading Index is now marginally below that of one year ago, with its smoothed growth rate fairly deep in negative territory.
Diminishing growth expectations are reflected in rising prices for Treasuries, especially at the short end. Because mathematically a 10 year Treasury is ten 1-year Treasuries, but the peculiar way bonds are quoted means that the first year interest of a 10-year bond is currently almost 300 basis points above that of a short-term T-bill means that as the near-zero rate structure has spread to 2-year issues, yields up to 10 years are being pulled down by those buyers who continue to hide out in longer-term but short maturities. Even the 3-year Treasury pays only about 3/4% interest per year.
The reluctance of bond buyers to go long-term on Treasuries has led to a further widening of the record spread between 10 and 30 year issues. This is currently about 120 basis points. Nothing is guaranteed, but sophisticated bond buyers know that in a constant yield environment with an up-sloping yield curve, part of the total return is implied price appreciation. In other words, let us say one buys a 10 year bond to yield 3% per year. In one year, one now owns a 9 year bond, which in this hypothesized rate environment yields, say, 2.75%. The owner of the bond pockets the 3% return and now can sell the bond at a higher price.
As an example, a 10-year zero coupon bond yielding 3% yearly is priced at 74.41. A 9-year bond yielding 2.75% is priced at 78.34. Thus holding a 3% bond for one year under a constant interest rate environment gives a theoretical total return of about 6%. Magic!
This sort of math does not work on the flat part of the yield curve, however. Where the yield curve today is relatively flat is in the 25-30 year segment for Treasury zeroes. There the more speculative short-to-intermediate term attraction is the prospect that, for example, the 10-year yield stays stable and a 5:4 ratio of 30-year to 10-year yields returns. That would imply a 30-year T-bond yield of about 3.5% and huge capital gains for owners of long-term zero coupon Treasuries.
25-year zero coupon yields on U. S. Treasuries are about 4.2% today. That's the downside assuming no default. That compares with total alleged historical returns from the American stock market of 9% per year. That number does not include trading costs, however.
Zero coupon taxable bonds, such as Treasuries, fit best into tax-deferred accounts, as the implied yield is considered as taxable interest by the IRS. I have been personally shifting cash (otherwise now defined as trash) into zero coupon Treasuries lately, both in taxable and non-taxable accounts. Thus I am for the nonce buying into the Japan scenario rather than the Grecian aspect of the duality of Federal finances.
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