The first week of October was a rough one for the TSP, with most funds showing negative performance.
The C Fund went down almost 1%, the I Fund went down over 2%, and the S Fund went down over 3%. Even the fixed-income F Fund went down almost 1%, which is quite bad for a single week in bonds. The only fund in the green is the G Fund, up a tiny fraction of a percent.
This week, beginning with Columbus Day, was off to a rough start as well.
U.S. Treasury Yields Hit 7-Year High
Pushed by higher short-term rates by the Federal Reserve and strong economic reports, the U.S. 10-year Treasury bond yields went over 3.2% last week, which is the highest level in 7 years.
On the chart above, 10-year Treasury yields are in blue, while the Federal Funds Rate (set by the Federal Reserve) is in red.
This rise in U.S. Treasury yields then affected multiple other types of bonds around the world, because investors weigh the risks/rewards of investing in various fixed income securities compared to U.S. Treasuries. If U.S. Treasury yields go higher, it helps pull up the yields of other types of government and corporate bonds as well.
This hurt the F Fund because as bond yields rose for newly-issued bonds, the prices of existing bonds fell so that the current yields match those new yields.
The G Fund, however, is special for TSP investors, because its yield is the average of all U.S. Treasury bonds with over 4 years in maturity, and yet unlike those longer-duration bonds its interest rate is reset monthly, meaning it has virtually no interest rate risk. In fact, it should benefit if interest rates of longer duration Treasuries move higher.
In addition, higher 10-year Treasury yields can indirectly affect equities, which is part of what happened this week.
When 10-year Treasury yields offer very low returns, investors that need decent returns tend to invest heavily in riskier assets like equities. However, when 10-year Treasury yields enough risk-free returns with higher rates, some investors pull a bit out of equities to invest more in these Treasuries.
Italy’s Fiscal Budget Threatens the Performance of the I Fund
Back in June, I wrote an article about Italy and Europe’s broader sovereign debt concerns and how this could adversely affect the I Fund going forward.
Here it is for reference: Tariffs, New Governments Could Affect the TSP
Italy’s issues came back to the forefront over the last two weeks, as Italy prepared to issue their 2019 government budget.
The European Union has what is called the Stability and Growth Pact. This pact sets limits on government debt and deficits for member states of the EU. Specifically, countries are not supposed to have a fiscal deficit over 3% of GDP or a total existing debt-to-GDP ratio higher than 60%. If their debt-to-GDP goes higher than 60%, they are supposed to begin reducing it each subsequent year.
This happened to many counties. For example, Germany’s debt-to-GDP ratio climbed to over 81% after the global financial crisis, but they have since reduced it to about 64% and continue to inch it downward still. Slightly more than half of EU countries are currently over the 60% debt limit, but most of them are managing it decently enough.
Italy, however, has over a 130% debt-to-GDP ratio, and it has been staying flat rather than going down for several years now. EU leaders are worried that Italy will be the next domino to fall like Greece did, except that as the third largest economy in the Eurozone, Italy is potentially too large to bail out and its affects could be more systemic.
The EU wanted Italy to release a government budget with a deficit of 1.6% of GDP or less. However, Italy released a budget with a deficit of 2.4%. This has set up a possible confrontation down the road between Italy and the rest of the EU.
Investors and analysts around the world watching this situation care in part about the numbers, but also about the sentiment of EU stability or political polarization between member nations. The worst-case scenario for Italy over time is that their debt keeps inching upward, and the next time there’s a recession in the country their budget could fall apart like Greece’s did, and send government bond yields to high levels that make Italy unable to issue cost-effective debt. It’s unclear to investors and policymakers globally what the EU would do in such a scenario, but it would be bad news for the I Fund.
Italy’s stock market has significantly underperformed the MSCI EAFE index (which the I Fund tracks) lately:
Italy is fortunately less than 3% of I Fund assets. However, about 65% of the I Fund’s assets are in Europe, and most European countries share the same currency and the same fiscal rules, so problems in one economy threaten to spread to other members if not resolved.