Blog

Yield curve follies

By Dwight Johnston on November 14, 2017 at 8:56 am

Bond market snapshot

Dow futures are off by about 20 points in pre-opening trading after a quiet overnight global session.

Bond prices are slightly higher to start the morning. The 30-year bond is showing the most movement as speculators and yield curve traders focus on the long bond. Bond prices rallied early yesterday on a German bond market rally, but the German rally fizzled and took the sizzle out of U.S. bonds. German bond prices are slightly higher morning. U.S. bond traders will continue to track German bonds until something here, possibly tax bill news, distracts them.

Economic reports 

In economic news, the Producer Price Index was up .4% and the core rate also rose .4%. These were higher than expected but of little concern to bond traders. The more important Consumer Price Index will be released tomorrow. Economists are expecting a .2% increase in the core rate. A .1% variation in either direction would likely cause a bond market reaction.   

 Examining the movement

At the urging of a reader you might know, Chip Filson, I thought I would spend a few keystrokes discussing the yield curve. You’ve probably read over the past few months several articles about the flattening yield curve. The articles are typically titled “What is the bond market telling us?” Bloomberg ran just such an article yesterday. The articles typically have the same slant. The bond market, with the flattening curve, is forecasting a recession or at least a period of slowness in the economy. I must take issue with the prognostication power of the yield curve, except when the yield curve is inverted.  

First remember the curve is relatively flat by historical standards, but the slope is not extraordinary and still a long way from inverted. An inverted curve, at least one that lasts more than a few days and is inverted all the way out, has always correctly predicted a recession, but flat curves have not. Remember that from 1994 to 1999 the curve was even flatter than now, yet it wasn’t until the curve started to invert in early 2000 that a recession followed. And this came after almost a decade of strong economic growth.

The article also stated that longer-term rates are unlikely to rise for two additional reasons. First, central bank buying. That was true, and it has certainly distorted the market, but that buying is coming to an end. The Fed will be completely out of the securities buying business by the 4th quarter of next year, and the ECB program is likely to be ending at the same time given the strength of the European economy.  months. The ECB program started at $80 billion per month, reduced to $60 billion this year, and will likely go to $30 billion next year. Unless extended, it will end in September.

Second, the article states the Treasury will concentrate more in the short-end issuance next year and beyond, thus the lack of buying by central banks will be offset. But with a deficit projected at $600 billion or more next year, there will be a lot of supply additional still in the long-end. People tend to forget our growing deficit will demand more issuance - in all maturities, and the Fed will be out of the buying business in a few short months.

But in the end, what will matter to rates in the long-run is inflation. If inflation rises, those huge leveraged bond accounts will be forced to sell and no amount of manipulation of maturity issuance will matter. If inflation goes nowhere, we could be looking at the ‘90s again but not necessarily an economic slowdown.

Yield curve movements have been distorted greatly over the past few years by an extended period (beyond reason in my opinion) of near 0% short-term rates and massive buying by central banks. Leveraged accounts have borrowed cheap and levered up their holdings. The shape of the yield curve has lost its meaning as far as “telling us” anything at this stage of the game. The long-end of the yield curve is a trading strategy, not a forecasting tool. That being said, wake me up when the yield curve inverts. Then I’ll pay attention.

Opening market reads

  • The 2-year is 1.69%
  • The 5-year is 2.07%
  • The 10-year is up 1/32 at 2.40%
  • The 30-year bond is higher by 10/32s at 2.855%
×

SIGN UP FOR DWIGHT'S DAILY DOSE!

×

OPEN AN ACCOUNT

Already have an account? Log In here.

Prefer to download the Account Application and submit via email?
Click here to download the Form.