Dazed and Confused?

The bond market might be taking this into account for in spite of the strong jobs data and rebound in manufacturing, yields of long-dated U.S. treasuries refuse to trend higher. However, there are other forces holding down long-term UST yields.

There is confusion regarding the bond market, the shape of the UST yield curve and the way UST yields have behaved. This confusion has materialized even among fixed income professionals.

A Wall Street Journal article, published last week, discussed the potential for continued bond market volatility. I was taken aback by some of the responses by fixed income market professionals interviewed for the article. One bond market participant told the WSJ:

“It is hard to figure out what is really going on with the disconnect between data and the bond market.”

Is there really a disconnect? When the tremendous demand for bonds from aging demographics around the world, a sovereign debt arbitrage which is occurring (see the 0.15% 10-year DBR and the -0.04% 10-year JGB) and that dataset correlations appear to have changed (due mainly to technology and globalization) are considered, low long-term rates are not all that surprising.

Another comment was somewhat more troubling, at least for me. A fixed income market participant told the Journal that movements in long-dated Treasury yields “are increasingly disconnected from short-maturity yield movements.” The truth is that the long and short ends of the yield curve often disconnect when the Fed is tightening or threatening to tighten. The same is true for easing, by the way.

2-year to 10-year UST Benchmark yield curve spread (Lower = flatter) (Source: Bloomberg):

The circles represent times when the Fed moved to a tightening/renormalization bias. Each time, the yield curve flattened. This is logical. As the Fed tightens, it makes the cost of capital more expensive. This makes lending to consumers more expensive which usually cuts down on consumer spending, which is disinflationary. Since long rates always move on inflation pressures/expectations (not growth, this is proved in the late 1970s/early 1980s when inflation and growth diverged), the yield curve flattens when the Fed tightens or is leaning in that direction. The curve flattens more dramatically later in a tightening cycle. That it flattens at the mere whisper of tightening is the bond market's way of telling you that the economy/inflation pressures are not strong enough to take much tightening. That most fixed income strategists, including myself, do not believe that the Fed Funds Rate peaks higher than the mid-2.00%s (if that) during this tightening cycle (if it can truly be called that) indicates that the bond market is probably not “wrong.” It rarely is.