There was a serious decline in the U.S. Treasury market on Thursday and Friday, accompanied by a sharp drop in the U.S. dollar, which backed over $1.40 against the euro. The 10-year T-note traded to yield 3.45% on Friday, and the 30-year bond almost reached 4.40%.
Yields are down slightly this morning, and the dollar is a bit stronger. (There is speculation that jitters over the North Korean nuclear blast are behind some of this action.) But it’s hard to miss a sense that sentiment is changing in this extremely important market.
Treasury securities have traded in a rather narrow range for weeks now, more or less since the stock market started rallying in early March. Typical yields for the 10-year note have ranged from 2.75 to 2.95 percent or so. (This maturity is the most critical for the economy and for the housing market.) But over just a few days, we’ve seen a sudden breakout to much higher yields in both the 10-year and the 30-year, while shorter-term yields have not moved as much. Thus, the yield curve has sharply steepened.
On Thursday morning, Standard and Poor’s changed their outlook on British government debt from “stable” to “negative.” These are terms of art which signify that S&P may at some point reduce its AAA rating on the UK. The stated reason was a lack of confidence that Britain would be able to square the circle of high public spending and poor prospects for economic growth.
That news story was followed quickly by a remark from Bill Gross (PIMCO’s chief investment officer, and one of the best bond traders in the world), that the U.S. might someday face the same fate.
About the same time, Tim Geithner was quoted as saying that medium and long-term Treasury debt is falling in price not because of a lack of confidence in the U.S. government, but rather because the economy is now recovering, and investors are ready to come out and start taking some real risk again. Have you noticed that when Geithner talks people have a tendency to assume the opposite of what he says?
So U.S. bond prices collapsed on Thursday, gold rose, and the dollar fell.
It’s entirely possible that the decline was mostly driven by technical factors. Last week was a short week, yesterday was a holiday, and today the Treasury starts up a large, three-day auction of new debt in the short-medium range of the curve. Those conditions often lead to massive short-selling by dealers, as they set themselves up to make quick profits from the Treasury’s issuance of new debt.
But the strong selling continue on Friday, when you’d ordinarily expect most market participants to already be on the harbor or on their way to the Hamptons. And the dollar and gold action doesn’t fit the pattern either.
Keep a weather eye on bond prices this week as the auction proceeds. If last week’s move was technical in nature, then we should see steady improvements in prices for the 10-year note and the 30-year bond. (The 30-year didn’t decline much faster than the 10-year, further supporting the theory that the move was technical.) But if the yield curve remains steep or gets steeper, then we’ll be asking whether there has been a sea-change in the market.
And that recalls Bill Gross’s comments last week. When you look at the prospect of the federal government standing to deficit-spend nearly $2 trillion this year alone, and almost certainly running huge deficits for many years to come, you have to ask who’s going to lend us all that money, and at what rate of interest. Several factors have so far combined to keep nominal interest rates relatively low for Treasury debt: there still is a large flight-to-quality trade as the world confronts continued economic uncertainty. The credit quality of the U.S., compared to corporate debt or the debt of other countries, is still by far the best. And of course, the Federal Reserve has been trying to keep rates low by directly monetizing (purchasing) outstanding Treasury debt.
Going beyond that, I think that the de-leveraging of U.S. businesses and individuals has a lot to do with this picture. As the private sector demands less net new credit and transitions toward holding less debt overall, that opens up supply from global investors, some of which goes to the Treasury.
But if there indeed is an economic recovery, there could be a sudden uptick in the demand for credit. At that point, it’s hard to see how we can avoid a big pulse of inflationary pressure and an updraft in interest rates. Global investors may have just started taking a close look at this possibility.
And what if interest rates rise sharply for risk-free Treasury debt over the next few years? It will only reinforce the broad trends already in place (some fundamental, some government-driven), toward lower overall returns on capital and lower economic activity.