What’s Happening to US Treasuries and Why Does It Matter?

The past month has seen US 10-year Treasury Note yields skyrocket, up almost 20% from the beginning of January to 2.8714%, as investors foresee a large boost to the US economy on the back of President Donald Trump’s tax reform and more activity from the US Federal Reserve Bank. Indeed, Chair of the Federal Reserve Jerome Powell recently stated that 2018 could see three or more rate hikes by the Fed to prevent the economy from “overheating”.

Figure 1: Australian 10-Year Treasury vs. US 10-Year Treasury Note yield

Source: BondAdviser, Bloomberg

This combination of rising interest rates, increased central bank activity and economic reform has pushed the US 10-year Treasury Note yield beyond the Australian 10-year Treasury yield for the first time since June 1984.

One may be wondering what US Treasury yields have to do with the Australian economy and one’s investment portfolio. As it happens, quite a lot…

US 10-Year Treasuries are used by many countries, including Australia, as a barometer for their own interest rates, with a historic correlation of 0.88 between US and Australian 10 Year Treasuries. A rising interest rate environment in the United States should therefore indicate that it is a matter of when, not if, the Reserve Bank of Australia (RBA) will make its first interest rate change since July 2016, when it cut the rate from 1.75% to the current level of 1.5%, and the central bank’s first rate rise since November 2010.

Figure 2: Bills Against Treasuries (BAT) Spread

Source: BondAdviser, Bloomberg

The graph above shows the Bills Against Treasuries or BAT Spread. The BAT Spread, being the difference between the 3-Year Treasury Bond Futures yield and the 90-Day Bank Bill Futures yield, is a key momentum indicator for future changes to interest rates. A positive spread (i.e. 3Y Treasury yield greater than 90-Day bank bill yield) indicates the market is expecting strong future growth and/or high inflation, and therefore higher interest rates, whilst a negative spread indicates lower inflation and/or economic growth expectations. The current sizeable positive spread of 0.22 demonstrates a strong market sentiment that the RBA could be raising interest rates to protect against growing inflation in the short- to medium-term.

An impending rate hike could spell trouble for the broader Australian macroeconomic environment. Australia ranks as one of the highest in the world for household debt to disposable income ratios, currently at an all-time high of 188.4% according to the Australia Bureau of Statistics (ABS). Of this debt, over 75% is tied up in mortgages, leaving the Australian population and economy significantly exposed to movements in interest rates and the cost of borrowing. Combined with rising underemployment, being the number of part-time workers actively seeking full-time employment, it paints a picture of uncertainty and in many respects the factors underlying this household debt could all show detrimental effects with interest rate hikes by the RBA.

Figure 3: Australian Household Debt & Employment Environment

Source: BondAdviser, Bloomberg

If the US Treasuries are indeed a signal of global central banking movements, and the RBA were to raise interest rates in the next 12-18 months, as many expect it to, this could place a significant financial squeeze on many Australian households, as well as the banks with mortgage loans on their books. Whilst the RBA will be carefully planning to avoid such a situation, the aggressive movements in US 10 Year Treasury Notes could be just the tip of an economically impactful and far-reaching iceberg.