(Bloomberg) — If you haven’t been paying attention to the persistent flattening of the U.S. yield curve, you’re way behind it.
Peter Cecchini, chief market strategist at Cantor Fitzgerald, calls it “the most important thing to have a clear idea about now.” Billionaire fund manager Bill Gross says we’re rapidly approaching a point at which the trend will induce an economic slowdown. Others claim it’s only natural, with the Federal Reserve raising short-term interest rates in the face of stubbornly low inflation.
To put it simply, the Treasury yield curve measures the spread between short- and long-term debt issued by the U.S. government. It’s the extra compensation that investors demand to lock away their money for an extended period.
No matter which theory of flattening you subscribe to, the world’s biggest bond market is sending a signal that traders can’t ignore. The longer the trend continues, the more likely its effects could spread to bank earnings and the real economy, while at the same time it would limit the Fed’s ability to respond when these risks emerge.
To get a sense of just how dramatic this trend has been, here’s a look at a handful of curve measures now versus the start of 2017. In trading Monday, they were all close to the flattest levels in a decade.
From two years to 10 years: 72 basis points, down from 125
From two years to 30 years: 119 basis points, down from 187
From five years to 10 years: 33 basis points, down from 52
From five years to 30 years: 80 basis points, down from 114
Everyone has their favorite theory for why this is happening and what it means for the economy and the markets, and all of them likely play a part so here’s a breakdown of each one:
It’s the Fed’s Fault
The simplest reason for the flattening comes from looking separately at what’s going on with short rates, the most sensitive to Fed policy expectations, and longer-term yields, which take their cues from the outlook for inflation and economic growth.
After years of balking at tightening monetary policy for fear of disrupting markets, Fed officials finally stuck to their plan in 2017, earning bond traders’ trust in the process. The two-year Treasury yield is at the highest level since 2008 as investors prepare for a rate hike in December, and begin to build up expectations for further increases next year.
With short-end yields climbing, the curve historically tends to flatten as longer-term rates rise more slowly. But since the start of 2017, 10-year and 30-year yields have actually declined. And the culprit behind that appears to be stubbornly muted inflation.
Even with U.S. jobs growth humming along and unemployment at the lowest level since 2000, the Fed’s preferred gauge of price growth was running at just 1.6 percent in September. It fleetingly rose above the central bank’s 2 percent target at the start of the year, but has since struggled.
This all raises the specter of what some call a potential “policy mistake” from the Fed.
That narrative “has ruffled a few feathers,” BMO Capital Markets strategists Ian Lyngen and Aaron Kohli wrote in a note last week. “Growth is moving at a solid clip and the labor market is ostensibly at full employment — so why aren’t we in an environment with a steeper curve and higher yields?”
Their conclusion is the Fed has built up a reputation as an inflation fighter. That means going forward, traders should expect a lower yield range for 10- and 30-year Treasuries than they might have otherwise.
Supply and Demand
Another factor pinning down longer-term yields: forced buyers, both in the U.S. and elsewhere.
Asset-liability managers like insurance companies and pension funds are always seeking duration, and 30-year Treasuries are among the best ways to get it. Combine that appetite with increased demand from passive mutual fund giants like Vanguard and BlackRock, and you’ve got a recipe for a sustained bid on the long end of the Treasury curve.
If that wasn’t enough, Treasury recently announced that it wants to focus increased issuance in bills and shorter-dated coupon maturities, like two- and five-year notes. That creates relative scarcity at the long end of the curve and a premium at the short end to absorb the extra supply.
Some see it as no coincidence that on the day of the Treasury’s refunding announcement, the yield curve from five to 30 years flattened by the most in two weeks.
“For all the discussions about the yield curve these days, one factor that is really driving positioning in the Treasury market is the expectation of future Treasury issuance,” Ben Emons, head of credit portfolio management at Intellectus Partners, wrote in a note.
To Cantor Fitzgerald’s Cecchini, those looking only within the U.S. to understand the yield curve are missing the bigger picture.
The global bond market is still awash in central bank purchases, he said, most notably from the Bank of Japan and the European Central Bank. And over the course of the past few years, the yield spread between 10-year Treasuries and German bunds has grown wider, creating an opportunity for overseas investors to add U.S. debt.
The ECB, led by Mario Draghi, announced last month that it plans to keep buying bonds through September 2018, albeit at half the current pace from January. It’ll also continue to reinvest proceeds from maturing debt for an extended period. The bank’s main refinancing rate has been pinned at zero since early 2016, sending yields negative on trillions of dollars of debt from Germany to Italy and the Netherlands.
“As long as the ECB continues to buy the long end of the curve, they’re in control of developed market long-ends, including Treasuries,” Cecchini said in a telephone interview. “It’s very hard to draw from history in this environment. The lessons from history only make sense if facts and circumstances are close to what they were.”
If one does take history at face value though, the $14.3 trillion Treasuries market is sending a warning about the economic outlook. Yield curves are the flattest in a decade, and it’s no coincidence that about 10 years ago marked the start of an 18-month recession. The yield curve has proven a reliable indicator of impending economic slumps when it inverts, and short rates exceed longer-term yields.
Lacy Hunt, chief economist at Hoisington Investment Management, sees a good chance of an inverted curve as soon as a year from now if the Fed continues to shrink its balance sheet. He says the tightening policy will likely choke off credit growth and curb excess reserves, slowing the economy and suppressing inflation.
Banks typically prefer a steeper yield curve because they generate income from the spread between long-dated loans and deposits that are priced on shorter-term rates. Without the gap, their performance suffers.
It’s already starting to show this year: U.S. financial stocks have trailed the S&P 500 as the yield curve has flattened. While banks’ lending margins have increased slightly from their 2015 lows, they remain below the average of the past 30 years, according to the Fed.
A potential increase in the cost of credit is at the heart of what worries Janus Henderson Group’s Gross.
“In a highly levered economy with a lot of debt, and that typifies the U.S., we don’t have to go flat, perhaps another 20 to 30 basis points of tightening would be enough in order to induce certainly a slowdown in the economy,” he said on Nov. 3.
The flattening trend may be a warning sign, or — to borrow one of the phrases Gross helped to popularize — it might just be “the new normal.” Either way, it’s a trend that’s poised to dominate bond traders’ decisions in the months to come.
I agree with Lacy Underall Hunt. Further rate increases and a Fed balance sheet unwind could lead to an inversion of the US Treasury yield curve. Inversion is when the 10 year T-note yield is below the 2 year T-Note yield. Inverted Treasury curves occur several months before entering into a recession.
Here is the US Treasury Actives curve today compared with December 1, 2006 when the yield curve was last inverted, mostly in the short-end of the curve.
Since Congress shows little interest in fiscal responsibility, one way Treasury can deal with the staggering fiscal deficits is to extend the maturity of US debt (aka, strectching out those debt payments).
(Bloomberg) — As the rest of Washington fixated on tax reform and a new Federal Reserve chair last week, the Treasury Department unveiled a borrowing strategy lacking fanfare but having potentially big implications for the bond market and the U.S. economy.
In a step that could limit upward pressure on long-term interest rates from bigger budget deficits and a reduced Fed balance sheet, the Treasury will break from a policy in place since 2009 and stop attempting to lengthen the maturity of the government’s debt.
“The Treasury is trying to avoid making the mistake of throwing out long-maturity debt where there isn’t sufficient demand, which could really steepen the yield curve,” said Gene Tannuzzo, a money manager at Columbia Threadneedle Investments, which oversees $484 billion. It “seems to be making an effort to avoid a yield shock.”
That’s important for the health of the economy. Yields on longer-term Treasury debt serve as benchmarks for everyone from home buyers to corporate treasurers. A “steepening is where we could get into problems with the housing market,” Tannuzzo said.
It’s probably also welcome at the Fed, which has begun to slowly reduce its balance sheet by not rolling over some of the maturing Treasury and mortgage-backed securities in its portfolio. Fed policy makers have gone out of their way to make the unwind as painless as possible for the bond market — and the Treasury’s new approach will help in that regard.
The shift comes as a surprise. It wasn’t that long ago that Treasury Secretary Steven Mnuchin was talking about issuing an ultra-long bond with a maturity of more than 30 years. While Mnuchin signaled he was backing away from that idea in a Bloomberg interview late last month, Treasury officials went further in the department’s quarterly refunding announcement last week.
“We’re looking at kind of a stabilization from here” in the weighted average maturity (WAM) of Treasury debt, acting Assistant Secretary for Financial Markets Monique Rollins said at a press briefing in Washington on Nov. 1.
Rising Maturities The average maturity of the $14 trillion-plus in marketable Treasury debt outstanding was at a near multi-decade high of more than 70 months on Sept. 30. That’s up from 49 months in December 2008 and is above the 60-month historical average dating back to 1980. It’s still, though, about a year less than the average of the Group of Seven industrial nations, according to data compiled by the International Monetary Fund.
The Treasury maintained its longer-term debt sales at $62 billion this quarter for the seventh straight time, opting to meet any increased financing needs from run-offs by the Fed through the sale of bills. The yield curve flattened in response as the attraction of holding longer-term Treasuries grew.
The department’s decision means that “at least initially, the Treasury is completely offsetting the impact of the Fed unwind” on long-term interest rates, said Seth Carpenter, chief U.S. economist at UBS Securities LLC in New York and a former Fed and Treasury wonk.
The central bank began reducing its holdings of Treasury and mortgage-backed securities in October, initially limiting the monthly draw-down to $6 billion of the former and $4 billion of the latter. The caps will be gradually increased to an eventual $30 billion for Treasuries and $20 billion for housing debt. [In fact, the unwind is so slow that you can barely see it compared to the $4.456 trillion left to unwind].
The alteration in the Treasury’s approach doesn’t mean the bond market will be spared from having to digest extra supply as the Fed unwind continues and budget deficits increase on the back of potential tax cuts.
Indeed, Treasury officials last week flagged the likelihood of stepped-up sales in future refundings. The department will “look at raising auction sizes,” Rollins said.
With The Federal government on a path of uncontrolled acceleration in spending,
Particularly with M2 growth outpacing real GDP growth YoY.
But at least the US Treasury 10Y-2Y keeps declining putting less pressure of debt refunding (and helping the housing market with lower 10 year Treasury yields).
Now that hopes for tax reform are gone (probably for a year), the US Treasury 10Y-2Y curve slope remains below 80 basis points. Far below where it was when Trump was elected President when optimism of something new (like tax reform) in Washington DC breathed life into the bond market.
According to Bloomberg, In the U.S., more than 3,000 stores did open in the first three quarters of this year. But almost 6,800 closed. And this comes when there’s sky-high consumer confidence, unemployment is historically low and the U.S. economy keeps growing. Those are normally all ingredients for a retail boom, yet more chains are filing for bankruptcy and rated distressed than during the financial crisis. That’s caused an increase in the number of delinquent loan payments by malls and shopping centers.
The debt coming due, along with America’s over-stored suburbs and the continued gains of online shopping, has all the makings of a disaster. The spillover will likely flow far and wide across the U.S. economy. There will be displaced low-income workers, shrinking local tax bases and investor losses on stocks, bonds and real estate. If today is considered a retail apocalypse, then what’s coming next could truly be scary.
Until this year, struggling retailers have largely been able to avoid bankruptcy by refinancing to buy more time. But the market has shifted, with the negative view on retail pushing investors to reconsider lending to them. Toys “R” Us Inc. served as an early sign of what might lie ahead. It surprised investors in September by filing for bankruptcy—the third-largest retail bankruptcy in U.S. history—after struggling to refinance just $400 million of its $5 billion in debt. And its results were mostly stable, with profitability increasing amid a small drop in sales.
Yes, this map looks very much like a map of the “subprime” residential mortgage crisis.
Let’s focus on Pittsburgh as an example. Watchlisted Commercial Real Estate Loans in the Pittsburgh, PA are include all property types. not just retail. So it is more than just the Amazon effect (on-line retail) causing the closure of retail space. In short, US commercial real estate developers built too much inventory.
One of the causes of CRE overbuilding? The Fed’s zero interest rate policy!