Treasuries Feel Effects of Tight Supply & Geopolitical Risks

• Treasury yields continued to march lower over the past week as an increase in geopolitical risks met a tight supply. We expect interest rates to fluctuate with geopolitical tensions in the months ahead.

Geopolitical Risks Continue to Introduce Volatility 

Yields on U.S. Treasuries fell to their lowest levels since June 2013 last week as geopolitical tensions further escalated (top chart). Russian troop movements across the Ukrainian boarder, along with ongoing skirmishes in Iraq, raised the risk premium. News cycles related to both of these events led investors to the safer Treasury market, pushing yields lower. In addition to the geopolitical turmoil last week, disappointing economic news out of Japan and the European Union also fueled investors’ appetite for lower risk Treasuries. While we agree that the slower growth figures from abroad were disappointing, we continue to expect growth, particularly in the European Union, to gradually improve through the end of this year. Should global growth show greater signs of stability later this year, investors may reduce their holdings of Treasuries, helping to support a higher rate environment. 

Tight Supply Compounds the Flight to Quality 

While it is not uncommon for yields to fall in light of increasing geopolitical tensions, the existing tight supply of Treasuries in the current environment amplifies movements in rates in response to global unrest. As we have commented before, the dominant factor affecting Treasury yields in today’s environment has been the constricted supply of Treasury Securities. Besides the purchases related to flight to quality and new liquidity requirements, net new issuance of Treasury securities has also declined, further tightening supply (middle chart). This reduced supply of Treasuries translates into greater volatility in rates when events, such as the geopolitical news of last week, begin to move markets. Given that the conditions for tighter Treasury supply are not likely to reverse course anytime soon, we expect that interest rates will continue to be susceptible to greater volatility in the months ahead. This greater volatility does not, however, change our views for the direction of rates through the end of this year and early next year. 

Outlook for Rates 

Still Points to Higher Yields Even with the dip in interest rate yields over the past week, we continue to expect rates to gradually rise through the end of the year (bottom chart). The exceptionally low yields from last week have already begun to reverse course as the news from Iraq and Ukraine appears, for the time, to be improving. With the Fed pointing toward a higher short-term rate environment in the middle of next year, shorter-term rates should start moving higher later this year and into early next year. The rate movement will, however, remain gradual and coincide with greater volatility due to the thin supply conditions. Of course, interest rates will continue to be susceptible to the ongoing geopolitical tensions along with further developments in the global growth environment.