"Treasuries out of line with interest rate expectations
The curious case of rising Treasury bond yields continues to attract various theories and explanations in the market. The latest doing the rounds is that it may have nothing to do with rising interest rate expectations at all. Rather, it is more about the yield curve becoming the function of an exceptional rate of supply, as well as some unusual market dynamics stemming simply from, well, unusual times.
Barclays Capital points out the Fed would otherwise have to raise rates to as much as 5.5 per cent by the end of next year to meet current market expectations based on the two-year yield. They suggest this is somewhat unrealistic given ongoing rising unemployment and negative pressures on the economy.
Among those backing the over-supply theory on Tuesday was also Dallas Federal Reserve president Richard Fisher. He told Fox Business news (our emphasis):
Long-term, as Milton Friedman said, sustainable inflation is a monetary phenomenon so we are going to have to be careful as an institution — the Federal Reserve — to make sure that we pull things back in, at the right time…And presently, I don’t believe the reason that rates are backing up has to do with a lack of confidence in the Federal Reserve. I think it has to do largely with a very simple phenomenon, supply and demand. There’s an enormous need for the Treasury to borrow. You mentioned the numbers earlier. Today about $35 billion will be financed through operations, $65 billion this week as you mentioned. Probably a trillion over this remainder of this fiscal year and under these circumstances, rates are indeed backing up as you mentioned in the Treasury sector, particularly at the longer end of the yield curve. I don’t think it’s unusual. I don’t think it’s wrong. I don’t think it’s odd. It’s just happening.”
In agreement too were primary treasury dealers. According to a Bloomberg survey, 15 of the 16 US government security dealers said policy makers would likely keep the target for overnight loans between banks in a range of zero to 0.25 percent this year. Bloomberg quoted one of the dealers as saying:
“The market seems wrong on this one,” said Eric Liverance, head of derivatives strategy in Stamford, Connecticut, at UBS AG, one of the dealers. UBS predicts that the Fed will remain on hold until June 2010. “High unemployment and a continued bad housing market will prevent the Fed from raising rates.”
Nevertheless, some still remain sceptical that massive supply alone can by enough of an explanation to justify the bond-yield conundrum. David Rosenberg of Gluskin Sheff writing on Tuesday was among those seeing some genuine inflationary forces at play. As he wrote:
The question is what is driving yields higher and what will cause the run-up to stop? Well, much is being made of supply and massive Treasury issuance, and to be sure, this has accounted for some of the yield backup but not nearly all of it — after all, Aussie bond yields has soared more than 100bps despite the country’s fiscal prudence. Clearly, the ‘green shoots’ from the data has been a factor forcing real rates higher. The doubling in oil prices and the rise in other commodity prices has generated some increase in inflation expectations, and the 40%+ move in equity prices and sustained spread narrowing in the corporate bond market has triggered a flight out of safe-havens (like Treasuries), and part of the move has been technical in nature owing to convexity-selling in the mortgage market with refinancings plummeting since early April. But, he added, those forces could easily be reversed by the end of the year:
Where we think the greatest potential will be is in inflation expectations — they should reverse course in coming months. Three different articles in today’s Wall Street Journal (WSJ) lead us to that conclusion: • More Firms Cut Pay to Save Jobs (page A4) • To Sustain iPhone, Apple Halves Prices (B1) • In Recession Specials, Small Firms Revise Pricing (B5)
The sudden flattening of the curve experienced in the last two sessions, meanwhile, did see something of a reversal on Tuesday. But, according to Barcap, that doesn’t necessarily mean the market should be counting on more steepening in the near-term.
As they explain, the continued unwinding of “steepener” trades on profit-taking, could very easily push front-end yields higher once again:
But while yields on traditional bond securities stay elevated, overnight rates in the Treasury repo market appear to be heading lower. Dow Jones reported on Monday that two-year treasury issues are now also so sought after that like just like 10-year securities they have begun trading at negative rates. As the wire report stated:
1601 GMT [Dow Jones] There’s still a severe shortage of 10-year Treasurys in overnight repo. And now the two-year’s also quoted negative, at -0.05%, though not as deeply as the -2.65% rate on the benchmark, according to GovPx. A negative rate means borrowers are paying an additional premium to get their hands on the security. All other issues trading close to 0.30% general collateral.
Treasury sell-off goes short - FT Alphaville
“The adjustment in the US Treasuries market is THE story in financial markets” - FT Alphaville
US Treasuries selling off, benchmark yield curve hits record wide - FT Alphaville
1) They think that the interest rate of the bond reflects the interest rate expected for the next two years:
"interest rate expectations"
2) There aren't enough 2 year buyers for the govts needs, so it has to raise the price by paying a higher interest rate:
"an exceptional rate of supply"
So, one group is holding out for higher interest because they know that the govt needs to pay them more right now, while the other group is holding out because they don't want to buy a bond at a yield below inflation going forward.
But shouldn't there be more demand if investors were certain that inflation was going to be below these yields? And shouldn't inflation hawks want a rate safely above the expected rate of inflation? Couldn't this then just be an equilibrium between the two? Or what am I missing? Everything?