The Yield Curve

 

Position: post the most recent weakness in the Treasury market, we covered the etf SHY today, but will re-short Treasuries on strength

 

The yield curve has been flashing in our notebooks over the last few months, especially relative to where it was at the start of the year.  We focus on the spread between 10s and 2s, which has widened from 158 basis points to 221 basis points from January 2nd 2009 to May 2st 2009.  As interestingly, the long end of the curve, specifically 30-years, has risen from 2.83% to 4.09%, or 126 basis points since the start of the year.

 

Historically, the 20-year Treasury bond yield averages approximately 200 bps above three-month Treasury bills.  At the start of the year, this spread was 316 bps and is now 398 bps, or an increase of 26%.  The standard interpretation of this steepening is that an economic recovery has become more likely and with this recovery there is an increased expectation of inflation.  Interestingly, the SP500 closed January 2nd at 929.6 versus its current price of 899, despite the fact that the yield curve is actually signaling that an economic recovery is more likely within a shorter duration.  In effect, the bond market is signaling an economic recovery, while the equity market is more uncertain. (Hint: Equity usually isn't the leading indicator.)

 

Aside from an expectation of an economic recovery and the related inflationary impacts, there has been a massive increase in the issuance of U.S. government debt over the last 6-months, which are naturally driving up rates.  According to Wrightson ICAP, the federal deficit is running at $956.8BN, or nearly one seventh of GDP, which is a level last seen in the mid 1940s.  In addition, according to the New York Times on May 3, 2009, "for all of 2009, the administration probably needs to borrow about $2 trillion." However we slice the numbers, the increase of U.S. government debt in 2009 will be massive and will come only with higher interest rates.

 

From a purely supply / demand perspective, the Federal Reserve announced in their March 18th release that they intend to purchase $300 billion of 2 and 10-year treasuries over the next 6 months to "improve conditions in private credit markets". To put this in context, the largest foreign owner of U.S. treasuries (China, or The Client) owns ~$750BN, so this is massive incremental demand.  The implication of this is that rates will be held artificially low while this purchasing program is being undertaken, but should naturally increase after its completion.  This incremental demand from the government is the lever that has likely kept rates at such low levels despite the dramatic increase in U.S. government debt that is anticipated. 

 

From a pure risk/reward perspective, it is hard to imagine that there is much downside to being short the short end of the yield curve with rates at all time low levels.  There is only one direction that these short term rates can go from a rate that is effectively zero - UP!  Now I know gentleman prefer bonds, but I also know that when interest rates go up, bonds go down.

 

Daryl Jones
Managing Director

 

The Yield Curve - a1