Long Bond's Short Shadow

Restarting the 30-year won't change the yield picture.
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The rebirth of the 30-year bond looks like a boon for the government, pension funds, insurance companies and some foreign investors. But for the dynamics of the fixed-income market at large, it may turn out to be much ado about nothing.

In a widely expected move, the U.S. Treasury Department said Wednesday it will start selling the 30-year Treasury bond again beginning next year. New sales of the bond were suspended in 2001, at a time when budget surpluses were expected to last for years. Since then, an economic recession, a series of tax-cuts and the Iraq War have turned surpluses into record deficits.

Faced with the possibility of a steepening yield curve, locking in current rates over a longer period made sense. "We believe this is a prudent debt management step that will continue to allow Treasury to finance the government's borrowing needs at the lowest cost over time," said Randal Quarles, Treasury undersecretary for domestic finance, in a statement.

Pension funds and insurance companies, among others, also favor the bond's return to better balance their portfolios between assets and liabilities over a longer term.

"There's growing demand for long-duration assets, one that may continue to build with pension reform in the U.S. and around the world," says BMO Nesbitt Burns interest rate strategist Michael Gregory.

Some countries, such as the U.K., France and Germany, for instance, are now issuing 50-year bonds, a move that the Treasury is excluding for now.

In reaction to the announcement, the price of the existing 30-year bond (which expires in 26 years in 2031) soared 23/32 and its yield fell to 4.50%. The benchmark 10-year bond rose 10/32 while its yield fell to 4.29%. The two-year note was up 1/32 and its yield down to 4.02%.

The move from the Treasury also comes at a time when global demand for U.S. bonds, together with deflationary pressures globally, are believed to have kept the benchmark 10-year note in high demand. That has kept downward pressure on its yield, which is used to benchmark mortgage rates.

Until recently, demand for the 10-year bond has led the yield curve to flatten as the

Federal Reserve

has continued to lift short-term interest rates. The central bank's key fed funds rate is now expected to rise to at least 4% by year end; two-year notes trade there already.

Back in late June, the 10-year yield was below 4%, though it has started rising toward 4.3% since then. Should the yield of the two-year note continue to rise while that of the 10-year bond stagnates, the result might be an inverted yield curve, which has traditionally foreshadowed recession.

Some have argued that the return of the 30-year bond could help cool some of the demand for the 10-year bond, and let its yield rise. Additionally, a greater supply of 30-year bonds would take away their scarcity premium and presumably push the long yield higher. This would have a "deflattening" impact on the whole yield curve.

The price of the 30-year bond was down ahead of the Treasury announcement but it rallied after as it appeared that the size of the new issuance won't be that huge. Tim Bitsberger, the Treasury's assistant secretary for financial markets, told

CNBC

that the issuance of long-bonds may total $20 billion to $30 billion annually.

But whatever happens in the bond market, it will be mostly technical in nature and won't have any drastic impact on the bond market, says Tony Crescenzi, chief bond strategist at Miller Tabak and a contributor to

RealMoney

.

"Supply isn't what's driving the U.S. bond market," he says. "One just has to look at the market's behavior as the U.S. went from a big surplus of $236 billion in 2001 to a $412 billion deficit this year."

In a vaccuum, the increased supply of government debt normally would drive up interest rates. "While that's still valid in emerging markets, the bond markets of industrialized countries react to fundamental economic factors," Crescenzi says.

These are first and foremost inflation expectations, as inflation erodes the value of bonds over time. Next is competition for capital, as bonds compete with other assets for investors' money. And finally, there's monetary policy, which makes it cheaper or more expensive to borrow.

All in all, the reintroduction of the 30-year bond's impact likely will take away some of the yield curve's flattening bias, but these fundamentals drivers still willbe ruling the market's dynamics, Crescenzi says.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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