Tuesday, December 29, 2009

A Rough Patch for Treasuries: Much Ado About Nothing?

The moderate rise of long-term Treasury yields since late November seems to have already triggered a flurry of stories in the financial press as to its underlying reasons as well as to whether it represents the first stage of a sustained, cyclical, uptrend in such yields.

As attempts at explaining this development have been pouring in, the most commonly offered explanations offered in recent days for the back-up in 10-year Treasury yields by about 60 basis points to the 3.80-3.90% range during that period are mostly zeroing in on the following factors: 1) The prospect that the economic recovery underway may ignite inflationary pressures down the road, 2) The massive budget deficits projected over the next couple of years, in conjunction with the Treasury's expressly stated plan to shift its new issuance toward longer maturities may ultimately cause the market to choke on supply, 3) The easing of the previous anxiety in global financial markets has led to a an increasing gravitation of foreign investors toward emerging markets, therefore abandoning U.S. Treasuries, which in the midst of the financial storm of the last 1 1/2 year had largely played the traditional role of a safe-haven.

Viewed separately, none of the above factors offer a credible explanation as to the timing of the latest sell off in the Treasury market.

First, on the count of inflation fears creeping back into the Treasury market. Hard to believe that such fears are indeed real. The latest round of inflation numbers have been, if anything, reassuring regarding the price picture. Core CPI was flat in November, having averaged 0.1% in the last two months, wage pressures remain non-existent, the labor market slack is at its highest and, by most indications, inflation (given that it is a famously lagging economic indicator) is widely expected to drift somewhat lower over the next 12 to 18 months, even as the economic recovery is taking hold. Moreover, the Fed is already openly, and methodically, positioning itself to start addressing the anxiety-generating issue of its "exit strategy", adopting a posture that can only be assumed to have a soothing effect on the market. To argue that, somehow, against this decidedly benign price backdrop, the Treasury market was abruptly invaded by intense inflation concerns, defies basic facts and stretches any sense of logic.

Second, in regards to the the presumed supply concerns and dismal budget deficit prospects. Sure, but this is nothing new that was suddenly revealed to market participants at the end of November. Forecasts of massive fiscal deficits have been around for nearly a year now and have not become particularly gloomier of late. Moreover, the end of the Fed's program to purchase $300 billion of Treasury securities (which was clearly viewed as a factor supporting the market) had already ended at the end of September (so, nothing new really) and the Treasury had already announced on November 4th its intention to increase its issuance of long-term debt without any immediate adverse reaction visible at the time. In other words, it does not appear that anything new broke on the supply front around the turn of the month that would justify a fairly substantial back-up in long-tern yields.

Third, the story about a steady increase in global investors' risk appetite-resulting into a massive influx of capital in emerging market economies is hardly a new one; it has been a dominant theme for several months now, with only a" manageable", and rather transient, adverse effect on Treasury yields previously.

Perhaps a better framework for interpreting the latest back-up in yields would require a more practical, down-to-earth, approach that takes into account some simple realities as to how markets function, and which often get brushed aside to make room for more rational-sounding "explanations".

To start with, the latest rise in long-term yields, both in terms of the magnitude of the increase and also the absolute levels reached, was nothing particularly unusual to justify the emergence of any new anxiety about the direction of rates. In fact, 10-year yields touched 4% in June- having risen by 150 basis points since early spring- only to drop again to below 3 1/4% by October. The transparent, and understandable, reason for the much sharper back-up earlier in the year was the realization that the economy was about to emerge from the recession and previous assumptions about the potential deflation risk were quickly downgraded. The subsequent realization that the economic recovery was likely to be of the moderate kind, by historical standards, allowed to a pullback in yields by fall.

What is often missing from attempts to explain the Treasury market's every twist and turn is the very realization that markets are notoriously emotional entities. As such, they often have mood swings that can be triggered by any set of factors, which may have been lurking in the background fairly innocuously for a while suddenly come to the forefront, becoming every one's favorite "reason" for a certain price action. While none of the three "explanations" discussed above in this article make sense in isolation, all put together form the semblance of a rational backdrop against which the latest rise in yields can be viewed. It is also crucial to recognize that the latest sell off took place in the midst of mostly thin, holiday trading, undermining its true significance further.

To be sure, with the economy switching into a solid growth pattern ahead and the Fed on standby to start reversing the exceptionally easy monetary policy at some point over the next six to twelve months, Treasury yields are likely to move on balance somewhat higher in 2010. This would be hardly a ground-breaking development worth endless stories with purported "in-depth" explanations as to its underlying reasons. After all, that is what almost always yields do when the business cycle turns. That rise may be quite a circuitous affair. In fact, when the timing of Fed tightening is viewed as within reach, markets, in true form, are likely to overreact and yields may initially rise violently in the context of a flattening yield curve, while such an overreaction may be subsequently tempered by the realization that inflation is likely to remain firmly under control with the Fed in a highly vigilant posture.

But over-analyzing a fairly "run-of-the-mill" rise in Treasury yields over the last several weeks is probably a case of much ado about nothing...

Anthony Karydakis


  1. Anthony,

    This article was enlightening, but I question your first point dismissing inflation fears.

    Rising yields (a catalyst for savings and more expensive debt), high unemployment, along with higher taxes on the horizon (potentially hampering investment) seem to set the stage for a deflationary environment.

    Isn't the fact that CPI remains propped relatively flat evidence enough for the existence of inflation?

  2. I do believe that the reverse perspective is more applicable here. The prospect of an unfolding economic recovery should have normally been the main driving force for some inflation concerns to re-enter the landscape, but this has not happened. Typically, in the early phase of the recovery, you would expect the disinflationary forces to melt away and be replaced with some inevitable gradual upward pressure in production resources (the unemployment rate will not stay at 10% forever). The absence of this dynamic in today's environment can only be indicative of a distinctly benign inflation outlook.