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For a second straight tumultuous year, U.S. Treasury securities ranging from 4-week bills to 10-year notes have outperformed the stock market. The year 2002 brought an anemic U.S. recovery, economic tension in several countries, civil unrest and potential war in the Middle East. All of these factors contributed to strong demand for U.S. Treasury securities, generally considered a risk-free safe haven in times of peril. The great demand has caused security prices to go up and yields to go down. Yields have fallen to their lowest levels ever for all Treasury securities.

It seems that the circumstances were ripe for such a run on Treasuries. A slowing economy has decreased demand for borrowing and allowed interest rates to drift lower. After reducing the federal funds rate target by 475 basis points in 2001, the Fed not only kept the low rates in place throughout 2002 but also reduced the funds rate a further 50 basis points to its lowest level in more than 40 years. Policymakers and equity investors are hoping that will do the trick and will create stronger growth in the U.S. economy during 2003. Eventually, healthy economic growth coupled with improved profit margins should lead to a rising equity market. In turn, the prices of Treasury securities will fall and yields rise. For now, however, Treasury securities are the more consistent performer.

Issue-by-issue update
Market demand for Treasury securities has increased in the past year as this risk-free fixed-income market continued to show a higher rate of return than the stock market.

The 3-month bill yield was steady throughout the year before drastically falling off after the surprise rate cut announced at the November FOMC meeting. With the federal funds rate at an all-time low, the yield on the 3-month bill fell even further to match it.

The 6-month bill shows the same trend as the 3-month bill, with its yield falling in the wake of the last interest rate cut. The yield on this security, as well as the 3-month, has been at or near lows never seen before. Three- and 6-month bill yields tend to move in tandem with the federal funds rate.

The 4-week bill marks another short-term maturity that closely follows the Fed fund rate. The Treasury introduced the 4-week bill last year to reduce uncertainty surrounding short-term borrowing, a problem with the prior policy of offering cash management bills on a sporadic basis. The chart above shows how similarly these three Treasury bills have traded over the past year. The only difference comes from a higher yield in the 6-month bill in the first half of the year. At that time, the stock market was performing somewhat better and there were hopes that the economy was starting to improve. Consequently, bond investors were beginning to think that the Fed would soon start raising its funds rate target. As it turned out, of course, the recovery proved anemic, and the Fed, instead of raising rates, lowered them instead.

The 2-year note is often viewed as a leading indicator of change in Fed policy. When the yield on this note is low and falling, it indicates that market players expect the Fed to cut rates. When the yield is rising rapidly, it signals expectations of Fed rate hikes. Perhaps the 2-year yield, at or near its historic low through much of 2002, was among the factors that led to the Fed's surprise rate cut in November.

Since economic activity has been so meager in the past couple of years, individual income and corporate tax receipts have come down drastically, thus raising borrowing needs for the U.S. Treasury. In the case of the 2-year note, this has led to a larger quantity of securities auctioned each month, now at the highest average level since 1996.

The 5-year note has likewise moved with the rest of the yield curve. Yields have fallen to historical lows in 2002 as the slowing economy, the weak stock market, and the geopolitical turmoil have all contributed to a run on safe-haven investments. Demand for this often overlooked maturity has slowly risen throughout the year.

The above chart shows the performance of the 10-year note, the fixed-income market's benchmark security. The past year has seen the yield on the 10-year note decline to historical lows. Several factors have affected this move down, including a slow economy and geopolitical instability ranging from the Middle East to South America. An accommodative Federal Reserve policy has also helped push down yields on this benchmark security. As the Fed has now reduced the fed funds rate to 40-year lows, there may be no other place for the 10-year note yield to go but up.

2002 marked the first time in over 25 years that no 30-year bonds were auctioned. While the effective rate of 30-year bonds during day-to-day trading has followed the rest of the yield curve, it does not seem that investors are missing the old bond.

Update on Buybacks
The official policy at the U.S. Treasury is that buybacks on the public debt will continue, although the Bush Administration has left this issue on the backburner. The Treasury has followed a very gradual approach to buybacks. A slowing economy and a burgeoning budget deficit have kept the buyback process from expanding in 2002.

In contrast to a couple of years ago, when budget surpluses were expanding as far as the eye could see, the Congressional Budget Office is now predicting annual budget deficits for the next few years. As a consequence, Treasury officials are holding off on declaring a buyback schedule, and in fact are unlikely to buy back securities any time soon. The Bush administration has been particularly interested in cutting taxes, a move that often lowers the chances for the government to operate in a surplus. While there are still proponents of eliminating the debt, these are few and far between in the new administration.

The Bottom Line
Where have all the changes left the Treasury market? It will be interesting to see how incoming treasury secretary John Snow deals with the budget and economic difficulties in the next year. He's likely to be given the benefit of the doubt, as many investors were tired of his predecessor's unpredictably and apparent apathy on the markets.

Where does this leave the individual investor? It depends on the separate needs of each investor. The past several weeks have shown substantial fluctuation in the Treasury securities market. Looking forward, investors who are shopping for yield may find that a rising interest rate market will benefit their portfolio. However, all those investors who bought Treasury securities at record low yields and high prices are likely to find that the value of their securities will depreciate if new bills and notes are auctioned at higher yields. But rates are not likely to change too much from current levels until real signs appear that the economy is improving. Then rates will rise. In the meantime, investors also face the uncertainty of war with Iraq. If such a war is fought in coming months, Treasury securities will once again be the mother of all safe-haven investments.

For now, the Treasury market is a mixed bet for investors, as the probability for a stock market recovery grows in the hopes that the current equity market has bottomed out and the economic recovery proceeds on track. This would trigger an adverse reaction in the fixed-income markets, making Treasury securities a hazardous investment.

Damir Fonovich, Market Analyst, Econoday