Tuesday, August 31, 2010

A Few Thoughts On The Current Treasury Yield Levels

With Treasury yields standing essentially at their lows for the year, having declined by over 50 basis points in the long end over the last four weeks, the obvious question that emerges now is "what happens next?".

A few thoughts on this topic.

1) Although the Treasury market rally can be extended further under a certain set of circumstances, revisiting the post-Lehman low of nearly 2% for the 10-year (reached in December 2008) should not be viewed as the odds-on bet at this point. At the time, the driving forces that caused the 10-year briefly flirt with the 2% mark were pervasive fears that another Great Depression was around the corner, with deflation and a possible meltdown of the global financial system to boot. The realization that those outcomes were not likely to materialize caused a very sharp back-up in yields in the first quarter of 2009, the point being that such extraordinary low yield levels are of questionable sustainability and can be reached only as a result of a certain alignment of special factors at work simultaneously.

The current environment is fundamentally different, inasmuch as there are still some scattered voices promoting a double-dip story and there is a fairly cool-headed debate as to how elevated the deflation risk truly is. Against that backdrop, the Treasury market rally has been largely fueled by the loss of momentum in the economic recovery over the last few months, the ensuing pullback in equity prices, and the broader perception that Treasuries remain a safe haven for global investors even in the midst of a relative calm on the European sovereign debt front recently. In other words, there are sound, legitimate reasons sustaining this rally, but the intensity of those driving forces is no match for those prevailing in the fourth quarter of 2008.

Based on the above, Treasury yields may find it hard to penetrate the 2 1/4% or so barrier (10-year) in the foreseeable future. To do so successfully, the market will need some new favorable developments, most likely of the "headline" type, to provide fresh impetus to the rally.

2) It is admittedly not a uniquely insightful statement to make that the extension of the rally from these levels can only mean one thing: a further flattening of the curve. This is so because most of the price action over the coming weeks is bound to be concentrated in the outer part of the curve, given the very limited room for improvement in the front end against a 15-20 basis point fed funds rate and no prospect of a change there as far as the eye can see. (It is also important to keep in mind here that the possible implementation of any additional quantitative easing measures by the Fed is unlikely to have any direct, material impact on the fed funds rate itself). In that context, a continuation of the rally is tantamount to a clean piercing of the current 200 basis points spread in 2s/10s, probably headed for the 185-195 bp range.

3) At these levels, the market is quite vulnerable to any upside surprises in the August payroll data on Friday (say, private payrolls +70K), or a more resilient ISM on Wednesday (holding up around 55.0), or another sharp decline in initial claims (-25K or so) on Thursday. Any such data, or combination of those reports, would start raising the prospect that the soft patch is waning and the pace of economic activity may be regaining its footing, causing a loss of momentum in the rally as the market takes a step back.

As is always the case, the employment data can cut both ways in terms of its impact on the market and, a distinctly weak report, can provide the new impetus that the Treasury market rally needs to march on. A decline of more than 25,000 in private payrolls, with a little changed unemployment rate, and moderate downward revisions to the previous two months' numbers can certainly make the 10-year set its sights on the 2 1/4% mark

Anthony Karydakis

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