Although there are sporadic hiccups, the equities market appears to be in reasonable order as stocks strive for continuous market highs. However, the message from the bond market is different.
Compared to longer-dated Treasury paper, the yield on short-dated Treasury debt increased more quickly this week. Two-year Treasury notes were earning 47.9 basis points, or hundredths of a percentage point, more than 10-year Treasury securities at the close of trading on Friday. This contrasts with the largest divergence of the year, which was 45.9 basis points on Thursday.
When investors are compensated more for holding shorter-term government debt than for longer-dated securities, this difference, or inversion, is typically indicative of more difficult economic times. Plotting the returns on debt maturing at different timeframes, the yield curve has been inverted for the greatest period of time in American history, and there are few indications that this situation will change.
It makes sense at first look. The Federal Reserve’s monetary policy decisions have a greater impact on the shorter end of the curve, and this week’s remarks from central bank officials dashed hopes for a summer rate reduction. The 2-year yield has gotten perilously close to the 5% mark due to predictions that near-term interest rates would remain higher for longer as the Fed continues to fight inflation and strong data on unemployment benefit claims.
“Bond markets on verge of breaking to higher yields…10 Yr not there,” wrote Andrew Brenner, head of international fixed income at NatAlliance Securities, shortly before heading to the beach for a walk on Friday.
As Wall Street celebrates the Memorial Day break, there are at least two stories being told about why the 10-year yield, which is responsive to economic growth, has been lagging behind the two-year to make the curve even more deeply inverted.
Brenner says investors dealing with the two ends of the curve seem to be focusing on different things. “The long end seems to be paying attention to a weakening economic scenario, but the short end is under fire from the Fed and some of the mixed recent numbers,” he wrote.
Expectations that the economy will slow, which would make rate cuts more likely, is a reason investors may be buying longer-dated debt now, locking in the current relatively high yields.
The Fed’s balance sheet is the other factor. The Federal Open Market Committee has decided that starting in June, it will let $25 billion of its bond portfolio mature monthly without using the money to buy more debt, compared with $60 billion currently.
The net effect is that more Fed money will flow into the Treasury market, which can drive up prices and push yields lower. That expected buying may already be weighing on longer-dated yields. New York Fed’s website shows that 34% of the Fed’s holdings of Treasuries mature in 10 years and over, the highest allocation to any group of maturities.
Investors should watch out for next week’s auctions of Treasury debt. Barry Knapp, managing partner of Ironsides Macroeconomics, says the sales could “put pressure on the back end,” taking the yield higher and prices lower. That may reduce the yield-curve inversion, if yields at the shorter end hold steady or decline.
Wall Street, for now, can enjoy the sunny weather and the long weekend. Until Tuesday.
