Credit Markets Overview: Treasuries Tide Turns

In the month since we introduced this feature, a tide has turned in the bond markets. Treasury yields, which on Oct. 23 were at or near their lowest levels of the year, have since tacked higher. For example, the benchmark 10-year Treasury note's yield, which stood at 5.59% on that date, ended yesterday at 5.82%.

Three factors explain the shift:

George W. Bush's lead in the presidential race. Right or wrong, bond market participants believe that a Bush presidency -- which at this points seems likely, if not assured -- will result in smaller federal budget surpluses than an Al Gore presidency, chiefly because Bush has proposed larger tax cuts than Gore. Because the Clinton administration has been using the budget surpluses to finance buybacks of Treasury securities, smaller surpluses mean fewer buybacks. The prospect of a less-rapidly shrinking supply of Treasuries makes them less valuable, causing their prices to fall and yields to rise.

The end (maybe) of the stock-market rout. For the better part of the last six months, the Treasury market's fortunes have been linked to the stock market. Looking at the stock market as a prime indicator of future economic activity, bond investors bought Treasuries when stock prices were falling and sold Treasuries when stock prices were rising. Fortunately for bond investors, stocks have experienced plenty of pain this year. But the worst of it came in mid-October, when the S&P 500 and the Nasdaq Composite Index made new lows for the year, and the Dow Jones Industrial Average came close. Now that the worst is over (at least in the S&P and the Dow), Treasuries have given back some of the gains they made at stock investors' expense.

Indications that the economy remains strong. On Oct. 27, the government's initial estimate of how fast gross domestic product (definition | chart | source ) grew during the third quarter was considerably weaker than expected, at 2.7%. That was welcome news as far as the bond market was concerned. But it was followed last Friday by the news that the job market remains as tight as ever. As measured by the employment report (definition | chart | source ), the unemployment rate held steady at a 30-year low of 3.9% -- a hallmark of a strong economy. Anyone who was thinking, based on the GDP report, that the Fed might lower the fed funds rate to stimulate the economy at some point in the next several months had to think again. On Oct. 18, fed funds futures were discounting 76% odds of a interest rate cut by the end of the first quarter. As of yesterday, the odds were 30%. Reflecting that reassessment, Treasury yields had to move higher, too.

Let's have a look around.

Treasuries

From a long-term perspective, Treasury yields are right in the middle of their range, at levels around 6%.

More recently, Treasuries have rallied, making them one of the best-performing financial assets of the year. Through the end of October, the Lehman Treasury Index returned 9.15%, compared with the S&P 500's 1.81% loss.

But after making or approaching new lows for the year on Oct. 23, Treasury yields headed higher.

Short-Term Rates

Short-term interest rates remain quite high by historical standards. At 6.5%, where it has stood since May, the fed funds rate is at its highest since January 1991.

Interest rate hikes by the Fed are negative for the bond market at first. But after a series of hikes, investors anticipate slowing economic growth and the end of the rate-hiking cycle. At that point, they start to buy Treasuries again, sending yields lower. From June 1999 to May 2000, the Fed hiked the fed funds rate by a total of 175 basis points , from 4.75% to 6.5%. The Treasury market started to rally this year in mid-May -- right around the time the Fed hiked rates for the sixth and most recent time. The 50-basis-point move from 6% to 6.5% marked the first time since 1995 that the central bank moved rates by an increment larger than 25 basis points.

High short-term interest rates have boosted yields on money market funds and bank certificates of deposit. The average retail money market fund yield was 5.57% in October according to Lipper, the highest since December 1991.

Source: Lipper

Mortgage Rates

Mortgage interest rates, like Treasury yields, are in the middle of their long-term range, at levels around 8%. Mortgage interest rates are a function of the market prices of mortgage-backed securities , which generally rise and fall with Treasuries because both classes of securities entail minimal credit risk.

Source: Federal Reserve

Mortgage interest rates improved with Treasury yields from mid-May to late October. But when Treasury yields stopped falling and started rising, so did mortgage rates.

Source: Federal Reserve

Corporate Yields and Spreads

Meanwhile, types of bonds that entail more than minimal credit risk -- specifically, corporate and high-yield bonds -- have been punished to varying degrees.

This is consistent with slowing corporate earnings growth, which weakens the ability of corporate borrowers to service their debt, prompting investors to demand higher yields.

The average investment-grade corporate bond traded at a yield of 7.82% in October, according to Merrill Lynch. In May, the average was over 8% for the first time since 1994.

The averages aren't pretty on an absolute basis, but compared with Treasuries they're downright ugly. That is to say, the difference in yield between corporate and Treasury bonds is even higher than it was in the fall of 1998. Then, investors fled credit risk en masse, and stampeded into Treasuries. As a result, Treasury yields fell sharply, while all other bond yields spiked. The difference in yield between the average corporate bond and the 10-year Treasury note swelled to 174 basis points in October 1998.

The same spread was even higher last month at 186 basis points. This is in some measure attributable to the shrinking supply of Treasury securities, which has increased their prices, lowering their yields. But even though the shrinking supply of Treasuries makes the difference between corporate and Treasury yields larger than it would otherwise be, the fact that it is at extremely high levels by historical standards still casts a pall over the market.

Source: Merrill Lynch

The high-yield bond market is in even worse shape. The average yield of 13.33% and the average 771-basis-point spread over the 10-year Treasury note in October were the highest since 1991. Yields rose substantially in the junk bond market in October, as they typically do when stock prices are falling.

Source: Merrill Lynch

This is a function of the rate at which high-yield borrowers have been defaulting on their debt. As measured by Moody's Investors Service, 6.08% of high-yield borrowers defaulted in October. Default rates higher than 6% haven't been seen since the last recession, when they peaked at over 12%. Moody's is forecasting that the rate will continue to rise.

Source: Moody's Investors Service

Muni Yields and Spreads

Like Treasury yields, municipal bond yields are in the middle of their recent range. The muni market normally tracks the Treasury market, because it's also a government bond market.

Source: The Bond Buyer

And, like Treasuries, muni yields have risen from their best levels of the year over the last several weeks.

Source: The Bond Buyer

Finally, as in the corporate bond market, the yields of low-rated muni bonds have been rising relative to those of high-rated bonds, reflecting rising concern about the ability of the weakest municipal issuers to service their debt should the economy continue to slow.

Source: Municipal Market Data (Thomson Financial Municipals Group)