Friday, May 21, 2010

Long-term U.S. Treasury Yields: Reaching For a 2% Handle?

The massive rally that has pushed long-term Treasury yields lower by over 85 basis points (as of this writing) since early April has spectacularly confirmed the unique status of that market as a safe haven in periods of anxiety and global financial turmoil. It has also set into motion a dramatically different dynamic and created a new reality on the ground.

What started as a localized fiscal crisis of a small, profligate, eurozone economy (Greece) morphed quickly into a major debt crisis engulfing a number of the bloc's economies. The turmoil that was set off in an expanded part of the sovereign debt market universe has shaken the foundation of the euro as a currency, calling into question the momentum of the economic recovery in many countries. In such a precipitously deteriorating environment, equity markets have taken a major hit around the world, making U.S. Treasuries the obvious place to be.

In an attempt to offer a perspective as to where this new dynamic may be leading the Treasury market, a number of points need to be recognized:

1) The underlying reasons that triggered the powerful Treasury market rally in the last several weeks are unlikely to disappear any time soon and an appreciable risk exists that they may actually become broader in scope and/or intensify. Although the headline risk related to the eurozone fiscal crisis as such may follow an "ebb and flow" pattern, the factors currently supporting Treasuries are multiple and intertwined, at the core of which is essentially a major repricing of global risk.

This leads to #2.

2) Even if one of those factors were to "normalize" somewhat in the coming weeks (say, a partial rebound of the euro or equities), any resulting damage to Treasuries is unlikely to be severe enough to send yields back close to their levels prior to the start of this rally. This was actually validated- on a smaller scale- on Thursday this week, where a rebound of the euro from its previously reached 4-year low against the dollar did not prevent Treasuries from pushing ahead with a strong rally for the day.

In other words, the current yield levels are slowly gaining legitimacy, as a reflection of broader concerns about the outcome of the deeply unsettled state of global financial markets, and may no longer be closely influenced by any single factor.

This paves the way for #3.

3) The key issue of whether the current financial market turmoil will end up having actually a significant adverse impact on the U.S. economic recovery (a view we do not fully subscribe to, yet: will require time to be sorted out, one way or another. Until then, the Treasury market participants will probably find "room" to front-run the prospect of an economic slowdown, which should continue to underpin the market.

And this brings us to #4.

4) There is a clear element of asymmetry as to how the Treasury market is likely to react to the various economic releases in the period ahead. Solid economic data will probably tend to be downplayed on the grounds that they do not yet reflect the slower growth that the market is implicitly pricing in. (This is especially likely to be the case if the unsettled conditions in equities, the euro, and sovereign debt markets persist). However, unexpectedly weak economic data will be quickly be viewed as validating the underlying narrative that the pace of the recovery is cooling.

Against that backdrop, and with the 10-year yield having already in its sights the 3% mark, regaining a 2% handle for the first time since April of last year is now a reasonable probability. Further continuation of the Treasury rally should continue to be led by the long end, leading to additional curve flattening, with the 2s/10s spread compressed to the 235-240 basis points range. The front end's upside potential will continue to be restrained by the fact that, after all is said and done, the fed funds rate is already at zero and there is an exit strategy somewhere looming in the horizon.

Anthony Karydakis

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