Thursday, April 1, 2010

On Long-term Treasury Yields

The moderate back-up in long-term Treasury yields since early March has been increasingly coming under the microscope in recent days as to whether it represents the beginning of a cyclical uptrend in yields against the backdrop of an economic recovery taking hold.

At first glance, the rise of the 10-year Treasury yield by about 30 basis points to 3.90% or so earlier in the week can be attributed to a number of factors: positioning for the end of the Fed's massive mortgage-backed securities purchase program (that ended yesterday), growing evidence that economic activity remains on a credible 3.5-4.0% growth path, the relative lessening of the anxiety surrounding the fiscal situation in some eurozone countries compared to February, and the ever-present onslaught of Treasury supply.

While all of the above factors are legitimate, they do not actually amount to a dramatically different landscape for Treasuries- at least, not yet. The Fed is likely to stay on hold for an "extended period" and the inflation data remain consistently benign in the midst of a large amount of slack that has been created by the memorable severity of the last recession. Besides, the current yield levels have not broken any new ground, as they had also been visited briefly in early January as well as last August (only to retreat appreciably afterward).

As we have argued before, at some point later in the year, a potentially more meaningful rise in long-term Treasury yields should not be ruled out, in the context of a major repositioning of the entire yield curve ahead as the Fed's exit strategy is drawing nearer. Even then, it is far from certain that such a reconfiguration of yields across the entire maturity spectrum will lead to a sustainable and significant rise in long-term yields, as the bulk of such an adjustment will most likely be absorbed by a drastic flattening of the curve.

In other words, breaching the 4% mark on the 10-year- a level that is tantalizingly close and also attracts some attention due to its status as "a big, round number"- should not necessarily be viewed as a prelude to a march toward the 4 1/2-5% range. Something material in the texture of the broader economic and financial environment will need to change for the latter to become the case- and we are not there yet.

Anthony Karydakis

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