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Tuesday, January 4, 2011

The Verdict on US Bond Yields?

By Claus Vistesen: Hull

Just before we turned the clock on 2010 I commented on the recent increase in US yields and noted the following simple issue;

How investors perceive and interpret this will [rising yields] determine great many things; is it a reflection of higher growth in the future and thus a sooner than expected normalisation by the Fed. Or is it a result of supply concerns and the continuing double digit budget deficit by the Fed and thus the bond vigilantes attempt to go for the biggest prey in the park.

Obviously, interpretation, animal spirits and sunspots can never be entirely disconnected from real economic activity on the ground, but the underlying point is important.

If rising yields are seen as a reflection of growing concerns over the US authorities' ability and willingness to control to the deficit it could hamper ability to maneuver for the Fed and the Treasury. If on the other rising yields are seen as a reflection of policy makers' success in reviving back growth through QE and an extension of tax cuts, it goes together with an altogether more benign narrative about how the deficit will pay for itself as higher growth leads to higher income and more leeway in managing public finances.

So which is it?

Well, a recent piece by Bloomberg's Daniel Krueger suggests that the latter discourse is emerging and thus that whoever playing the part as bond vigilante these days, he or she has failed in their attempt to drive the conversation (so far).

Quote Bloomberg

The worst performance by Treasuries since the second quarter of 2009 reflects prospects for faster U.S. economic growth rather than concern that rising budget deficits will drive investors away from government debt.


Even as deficits remain at almost record highs, the bond market is giving the U.S. time to address structural budget imbalances. A Bloomberg News survey of the 18 bond dealers that serve as counterparties to the Federal Reserve in its open market transactions show they forecast the 10-year Treasury yield to rise to 3.65 percent from 3.30 percent on Dec. 31, below its average of 4.33 percent since 2000. Two-year yields will climb to 1.05 percent from 0.59 percent, holding below the average of 3.03 percent since the beginning of 2000.


“The market is starting to believe the Fed will be successful in creating growth,” said Ray Humphrey, who manages inflation-indexed bond portfolios in Hartford, Connecticut for Hartford Investment Management Co., which has $161.7 billion in assets. “Nominal bonds are frankly reflecting those higher growth rates.”

This is interesting for a host of reasons. First of all, with an estimated budget deficit of 10-11% of GDP in 2011, it seems that the old adage that the US economy is indeed different still holds true. Consequently, and local government debt/muni ghosts notwithstanding it appears the US economy is getting all the leash other economies in the OECD are not.

Looking at the charts, I would not hold it against you if you thought that this was much ado about nothing though.

(click for larger image)

In general, the US yield curve has steepened considerably since the infamous March-09 low in risky assets mainly as a result of the fact that although short term yields have been kept tightly in check by the Fed's policies, yields on longer dated bonds slowly crept upward in 2009 with both the 10y2y and 20y2y increasing notably. This in turn, albeit with a lag, has sparked comment from both Fed officials and prominent analysts that the Fed would use additional QE measures to massage the long end of the yield curve especially as it is the long end which determines the rate on mortgages which is a gauge strongly watched by the Fed.

In 2010 and much contrary to the talk about rising yields; both long term and short term yields have actually declined on the year. From December to January it is pretty much status quo on the yield curve measured by the 2y10y though with 2 year nominal yield declining 31.3 basis points and 10 year nominal yields declining 44 basis points.

The action and talk on rising yields come from the fact that in Q4 yields have increased across the board with longer dated bonds taking the worst hit as the curve steepened across all spreads. 10 year yields rose the most from October to December rising 75 basis points while 2 year yields increased by a mere 24 basis points in comparison. As such, what turned out to be a good year for bond investors has turned sour right at the end.

The real important thing going forward is how long US policy makers can benefit from the win-win discourse of rising yields and a strenghtening economy. One would be tempted to say that if only the Fed came out openly and targeted a level of the SP500 then the world would be much more transparent. What I am basically saying is that one key part of the Fed's current policies is the explicit targeting of equity prices and the subsequent positive wealth effect perceived as well as real.

Fundamentally, it is bit of tighthrope walk since the main condition for the good days to continue is a very fine balance epitomized by the notion of a "mild-goldilocks" scenario. In short, yields can go up as long as they want except if it translates into the actual expectation of an interest rate hike by the Fed. As such, the economy should continue growing but not so strong as to force the Fed's hand into a more hawkish discourse.