Well we finally got some press. By we I mean those of us who toil in the bond market. For those new-paradigmers who are convinced that the
is the only capital market in the world, events in the last few days have given us our 15 minutes of fame.
I usually start my mornings with some coffee, a few cigarettes and
does about five seconds a day on the bond market, usually just as filler until the next "
36,000" guest arrives. Flipping on the tube last Friday, I fully expected another breaking story on how bubble.com's stock split led to a 50-basis-point pop in
When the bond market, and more specifically, the yield curve was the top story, I genuflected at my "rates-up/prices-down" fixed-income altar and settled in to listen. Though
nailed many of the factual happenings in the bond market over the last few days, it missed the nuance of what was really going on.
Having just traded through the most volatile bond market in years, I thought I'd share the insiders' view of what is going on, why it's happening and what the ramifications are for the future of monetary policy and the markets in general (except, of course, for the
, where even saltpeter is a stimulant).
What started as a simple announcement about the federal government paying down some of the national debt early exploded into a fear that caused the well-greased wheels of our capital markets to squeak in protest last Thursday morning.
Prior to the announced paydown, which was slightly larger than originally thought, yields on the 30-year Treasury were a tad higher than on the 10-year bonds, consistent with the recent flattening that had taken place as expectations for rate increases accelerated.
Responding to the reduced supply, the market began to bid up long Treasuries to the point where, in the middle of last week, the spread between the 10s and the 30s inverted to about 10 basis points, meaning the 10-year yields were higher than the 30-year yields. Normally, the yield curve slopes upward, with longer-maturity securities commanding higher yields for their increased interest-rate risk.
OK, that makes some sense: lower supply, same or increased demand, mild inversion. The real trouble started Jan. 28, when a stronger-than-expected
report, combined with troubling price pressures as evident in the deflator, led to a more serious inversion, peaking around 25 basis points during the day.
Why? Here's my take. As the curve began to invert, investors of large sums of money -- often leverage money -- were betting that it was a short-term phenomenon. With the release of Friday's data, the likelihood of a more aggressive
action increased the chance of higher borrowing costs for the leveraged money expecting the curve to steepen, forcing them to buy bonds to cover their shorts. Whew -- a little shaky but the bond market got through it.
Cut to Feb. 3. Everything seemed to be progressing as usual; the long bond was a little softer,
was up about 14, etc. At 7:45 a.m EST, things went ballistic. What was the spark? The
European Central Bank
raised its short-term lending rate 25 basis points to 3.25%. Instantly, the long bond rallied almost two points to yield 6.10%, the curve inverted to minus-45 basis points, swap and corporate spreads exploded and the credit markets seemed to freeze.
Though no one is really sure what triggered the debacle, I maintain that the unexpected increase in European short rates caught the hedge fund community off guard and those 10/30 steepeners (those betting the curve would flatten) who financed their leverage overseas were trapped.
Hedge funds, in their desire to provide above-market returns in exchange for dizzying levels of risk, scour the world for cheap places to finance their borrowing. Any increases in those borrowing rates prompt them to sell longs, cover shorts, and often times, change shorts.
The dash for the long bond and
the long bond was frightening. Bond futures were stronger by less than half of the cash bond -- meaning it wasn't a duration-driven run -- and the aroma of a full-fledged squeeze began wafting across trading desks. "So-and-so's going under!" "Emergency Fed meeting!" "Clinton to seek third term!" The fright was palpable. We didn't settle down until early in the afternoon, and the market continued to walk on eggshells.
So what does all this mean?
in a box. The powerful rally in bonds, whatever the cause, may stimulate the economy just when the chairman is trying to slow it down. Though corporate borrowing costs haven't changed, lower Treasury yields have emboldened equity investors (as if they really needed it) and the resulting wealth-induced spending should also serve to make the chairman lose some sleep.
Will these combined events make it impossible for the Fed to contain growth and potential inflation? Well nothing's impossible, but the Fed's lack of aggressiveness over the past few months has left some bond participants wondering if the Fed is farther behind the curve than most investors realize. If that's true, tapping on the brakes becomes less of a viable option; the chances of a brake-slamming 360-skid increase daily.
But at least that won't bother the Nasdaq.
Jim Sweeney is the head of fixed income investments at Aeltus Investment Management in Hartford, Conn. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. Aeltus manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. While Sweeney cannot provide investment advice or recommendations, he invites you to comment on his column by writing his colleague Jim Griffin at