What Is the Bond Market Telling Us?

Editors note: This is a guest column from money manager and economist Brian Reynolds, a chartered financial analyst. We welcome your feedback about this column at [e-mail] .

Ah, the week before Labor Day. What a perfect time of year to kick back and relax -- and talk about bonds.

I know, I know. A discussion about bonds is enough to make most anyone's eyes glaze over. If economics is known as the dismal science, bonds can be called the dismal investment. Not as sexy as equities, bonds have their own peculiar lingo and trading mechanics. They are often no more than an afterthought to most people. Savvy investors, though, know that the bond and stock markets can give important clues to each other. As people prepare for the back-to-work post-holiday crush, it might be useful to look at what the bond market is saying now.

Lately, there have been stories about how low Treasury yields are relative to the Federal Reserve's target for the fed funds rate of 6.5%. Commentators have also noted how the Treasury curve has inverted this year, with longer maturity issues yielding less than shorter ones. At the end of last year, the curve had a normally shaped, positive slope to it, as investors usually want to be compensated more to own longer-term (and thus riskier) debt. History would suggest that current trading levels provide evidence that bond buyers are convinced that the Fed is about to embark on a round of rate cutting. Why else would someone buy a 30-year bond that yields more than one-half percent less than a two-year issue, which is in turn earning almost a third of a percent less than the fed funds target?

Treasury Yield Curves

Source:Federal Reserve Board

However, history may be (as James Cramer would say) Wrong! It used to be enough to just keep an eye on a few key levels to get a good picture of the bond market. That has all changed in the last few years. The swing from large federal budget deficits to surpluses has made the task of following the bond market much more difficult. As the chart below shows, we will have had three years in a row of surpluses come October. Fiscal year 2000 will produce a shrinkage of Treasury debt of more than $200 billion.

Federal Budget Deficit/Surplus by Fiscal Year, $ bil

Source: CBO, including FY 2000 est.

Faced with the economically pleasant task of having to retire more debt than is maturing, the Treasury has been buying back issues on the open market, but not just any issues. They have been trying to manage the average maturity of the entire amount of all Treasury debt outstanding. If they bought back only short-term issues, then the average time to maturity of the remaining debt would skyrocket. If the current low inflation environment were to continue, then the government would be faced with paying relatively high coupon payments for many more years than necessary. To keep the average maturity down, they have been buying back longer issues. This demand has produced the inversion of the Treasury yield curve.

Prospects for continued surpluses and buybacks are helping to sustain the negative slope and may in fact lead to even lower Treasury yields. If George W. Bush were to be elected president, his promised large tax cut would cut sharply into the surplus. Promises aren't always kept in Washington, and his cuts might not be enacted in full by a Congress that stands a good chance of having more Democrats than it does now -- remember how the Republicans were able to stop President Clinton's early proposals. Al Gore also wants to cut taxes, but not by enough to impair the surplus. Any tax would probably not be enacted until well into 2001 and not take full effect until at least 2002. There will be a lot of debt retired between now and then, and that's what many Treasury investors are betting on.

What does this mean for the economy? Not as much as it used to. Not only has Treasury debt been shrinking, but the economy has been growing. This implies that (and this is heretical, coming from an old bond manager) the Treasury market isn't as meaningful as it used to be!

Public Federal Debt as a % of Nominal GDP

Source: CBO, and author's estimate for FY 2000

This doesn't mean that Treasuries have become irrelevant. They are still a large and important sector, but when a market becomes overwhelmed by technicals, it can prove valuable to look at other benchmarks to see if they offer a confirming view. The corporate bond market fits that bill.

The rates on corporate bonds are what really matter to companies, as that is what they must pay to issue new debt. As Treasury issuance has fallen, new corporate bonds have picked up the slack. This is a reverse of the "crowding out" effect that occurred in the 1980s and early 1990s when government borrowing ballooned. In fact, by dividing the taxable bond market into four broad classes (Treasuries, Government Agencies, Corporates and Mortgage-Backed), it can be seen that the corporate market has become bigger than the Treasury market.

Publicly Traded Debt Market Share by Sector

Source: FRB Flow of Funds, author's estimate for 2000

Corporate-bond yields are often measured by how much more they yield than Treasuries. Adding this "spread" to a Treasury yield will produce the corporate's yield. Plotting corporate yields against the Treasury curve reveals interesting insights.

Treasury & Industrial Yield Curves by Credit Rating

Source: FRB, Bondsonline.com

A look at different corporate curves shows that they are positively sloped. If bond investors were really convinced that a round of rate cuts were in the offing, then the corporate curves would probably be inverted as well.

So while the Treasury market may be poised for further gains, it looks like they may be a result of changing supply and demand dynamics, not from any imminent Fed cuts. The good news is that, because corporate curves are not extremely upward sloping, bond investors are not expecting a further string of tightenings, either.

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Brian Reynolds spent 16 years as a fixed-income portfolio manager and economist at an investment management firm in Cambridge, Mass. He currently trades for his own account. At the time of publication, he is long Treasury Index Funds, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell. He welcomes your feedback at [e-mail].