The bond market has been acting pretty crazy recently, as I noted
last week. Since the early November lows, two-year Treasury yields have risen about 56 basis points, while 10-year yields are up about 78 basis points. Let's examine why it's behaving this way and what it likely means for the economy.
Earlier this week
The Wall Street Journal
looked at some factors in the mortgage market that are
influencing yields. The end of the dealers' fiscal year in November is also probably hurting Treasuries. As dealers rebuild their corporate bond inventories and bring more deals to market, they'll often short Treasuries in an attempt to hedge their market risk.
However, these are merely contributing factors. Bond managers' belief that the economy or inflation is about to come roaring back has primarily driven the recent yield rise. After bonds have had a decent year, especially in the short maturities, the temptation may also be coming to lock in profits before institutions' fiscal year-end this month.
If the economy does come back strongly (or even modestly), this will be good for corporate bond spreads, because I think the currently wide spread levels mean that corporates are priced to
anticipate a particularly nasty credit cycle.
The selling in the bond market has pushed long yields up more than short yields, steepening the yield curve. Since I
looked at the curve in September, the two-year to 10-year spread has widened from 179 basis points to 209 as of Tuesday night. The last time the curve was this steep was in 1992, when it peaked at 262 basis points.
Many observers view a steep curve as a harbinger of a stronger economy: the steeper the curve, the stronger the economy. Indeed, after that 1992 peak in steepness, the economy finally got into gear in 1993 after three years of no better than sluggish growth.
However, I have a different view of the curve's meaning. I feel a steeper curve is an
of bond managers' view of the economic outlook. It doesn't necessarily mean that this view will come to fruition. Bond managers have been known to be wrong. The most notable instance occurred this year: Managers have felt from the time of the
first rate cut in January that the economy would be reviving fairly quickly.
To me, the direction of yields is at least as important as the steepness of the curve. In the 1990-92 experience, the Fed brought short rates down from 8% to 3%, but long rates fell only modestly during much of that time as managers felt the Fed was being too easy. This was probably a major reason why the economy stayed sluggish coming out of the 1990 recession. It wasn't until 1992, when the curve was at its steepest, that long yields really rallied and produced a better economy in 1993.
The current situation has several similarities, but with a twist. Again, bond investors feel that the Fed has been too easy, but long yields are rising as the curve is steepening. Going back to 1976, the earliest we have data for the two-year bond, the curve has never steepened to beyond more than 100 basis points while accompanied by a rise in long-term yields. I've said before that I believe the higher cost of capital and lack of mortgage refinancing opportunities will make it harder for the economy to accelerate, so I still think
a modest recovery is the most likely outcome.
What worries me is the resurgence of the "Armageddon" trade that I
wrote about last spring, in which bond managers drive yields up until something breaks in the economy. The recent sharp advance in stock prices has started bond managers worrying that a "bubble mentality" may be returning to the equity markets. As happened last spring, I'm starting to hear bond managers say things like, "If this continues, we'll take yields up so much that we'll stop the economy from getting going even before it has a chance to start." (Please don't shoot me; I'm just the messenger here.)
I think the equity markets
can be viewed as fairly valued or better against some types of bonds, especially shorter ones, but it doesn't really matter what I think. What matters more are the opinions of my former competitors who manage hundreds of billions of dollars, and they're concerned about the possibility of equities continuing to advance at their recent pace.
For a change, the bond market didn't react negatively to Tuesday's Fed rate cut. Hopefully, that means bond managers won't wreak havoc on the economy, but investors should still re-examine their portfolios to make sure they're taking the right amount of risk for their financial situation. I cut my long Treasury weighting after the brief rally that ensued after the
Treasury's decision to eliminate the 30-year bond. (In hindsight, I wish I'd cut even more, but that's why I own more stocks than bonds.) If the curve does steepen significantly more from here, I'd consider adding again to my long Treasury holdings. I'll have more thoughts on where I see risks and returns in the bond market in future columns.
Brian Reynolds is a chartered financial analyst who spent more than 16 years as a fixed-income portfolio manager and economist at David L. Babson & Co. in Cambridge, Mass. He currently writes and lectures about investment issues and trades for his own account. At the time of publication, he had no positions in any of the securities mentioned in this column, 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 feedback at