The yield curve continued to flatten yesterday as the 10-yr note broke 4.00% for the first time since October of last year, although gains were forfeited today with the spread between the Fed funds and the 10-yr note now at 1.57%. This yield contraction is indeed odd considering we are well into a Fed tightening cycle and core inflation is creeping higher, albeit slowly.
There are two ways of viewing the current bond market: 1) a market manipulated through government intervention/policies, or 2) a market simply fulfilling its role as a discounting mechanism.
1) FCB/US Treasury Manipulation View:
We all know of the relentless foreign central bank buying of dollars and thus US Treasuries – initiated either because of structural commitments (maintaining a dollar peg) or a dependency on export-led growth. We also know of Treasury’s debt management policies of increasing the stock of short-term treasuries while decreasing the stock of longer-term treasuries – shortening the average maturity of outstanding government debt – while ultimately squeezing the supply of the 10-yr note. These factors have contributed greatly to the underlying strength in the bond market in spite of bearish economic undertones.
FCB intervention will continue to provide lift for the bond market until they change current FX policy or when export-led growth is supplanted by domestic led growth in their countries. Due to recent underlying strength in the bond market, previous speculation of foreign central bank diversification out of dollar assets was probably a bit premature (although we won’t know for sure until BIS and IMF data are released).
Treasury’s policy of shortening the average maturity of outstanding debt, although still prevalent, is less appealing today than it was when the yield curve was steep. After all, the rationale behind the idea was to take advantage of low interest payments at the short-end of the curve when the Fed held rates low.
Nevertheless, these two factors have produced a “dishonest” yield curve, in that the current yields do not convey true market expectations.
2) Market Discounting View:
The market can also be viewed for what it has always been: a forward-looking, discounting mechanism. If we ditch the FCB / US Treasury manipulation analysis, and take up the pure market discounting view, we’re headed for a ditch - at least according to the bond market:
The bond market is discounting something short of deflation (the economic ditch). Today long-term yields are at the same levels as they were before the Fed dropped its deflationary bias. So, if the Fed is confident enough to raise rates 150 bps on the assumption that economic growth is sustainable, what’s freaking out the bond market?
I’ve previously pointed to the growing importance of the short-end compared to the long-end of the curve. Basically, as pointed out above, the Treasury has shortened the maturity of all outstanding government debt (creating a higher supply of short-term debt). Couple this with an old Bill Gross concern (refer to my 1/13 post) where corporations swap long-term debt into short-term floating rate paper to reap the benefits of lower interest payments, and you have a situation where the US economy is all the more dependant on rates staying low at short-end of the curve – especially the Fed funds rate. With exposure being greater on the short-end during this tightening cycle compared to previous cycles, the effects of each 25 bps move by the Fed are being magnified. Aside from the impending profit sqeeze, reduction in economic growth, and increasing pressure on equity prices - all brought about by a higher discount rate - this speaks directed to the myriad of current asset bubbles – the ultimate concern for the bond market. I’m concerned most with bubbles originating from non-consumer debt as mortgage debt payments are still low and not as sensitive to moves in short-term rates. Those more exposed and vulnerable at the short-end include major players in the bubbling private equity market – hedge funds, venture capital funds, LBO firms; a concern held by Mark Anson, investment chief at CalPERS (California Public Employees’ Retirement System), the biggest pension fund and largest investor in venture capital funds in the country.
There it is – two competing views of the current bond market. Pick your poison.
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