Yield Curve Steepness Is Not Signaling Economic Recovery

Like most things, treasuries are not functioning in this environment as you would expect. There are external fundamentals at play that are distorting the prices we are seeing and are making the simplest of investing decisions more complex.

Take the steepness of the yield curve. People use different durations to make these observations. Some look at the 2-10 spreads, others the 30-day-10-year spread. I am using the 2-20 spread.

What we are used to seeing is a steeper yield curve signaling some sort of economic recovery. As conditions improve, investors demand a higher yield in exchange for locking up the funds for a longer duration. It also signals rising inflation expectations as putting away money for the longer term looks less attractive and yields are forced higher to meet demand.

If you look at the chart above, we are fast approaching the steepness of 2002, which is around the time that the bull market began which lasted until the current crisis. However, my analysis suggests that the signal of an economy about to turn is incorrect. The yield curve is steepening for other reasons. Here are a few possible explanations:

1. Pressure on the front end of the yield curve - This was caused by safehaven buying and repatriation by Americans of foreign investments looking for a place to park their cash and earn a little yield. There is also the (not so small) issue of margin calls. As the markets came crashing down and as hedge funds fell into the loop of selling to cover margin calls causing further price drops and further margin calls, the need to raise cash as collateral increased. As far as margin goes, treasuries are considered to be as good as cash. What we have seen is a stampede into treasuries by large investors and managers in order to maintain their margin levels and earn some yield in the process (as opposed to posting cash).
2. Long end over supplied - And supply is expected to increase. As the U.S debt increases and the yearly budget deficits grow, the government is expected to try to fund the costs of current and future bailouts with longer dated maturities. They are trying to avoid what is already a big issue in the corporate world - rolling short term debt. With yields under 5% and being dragged lower by Fed rate cuts, it's a great time for the government to fund its long term liabilities. That being said, rates can't go much lower and once the Fed runs out of ammo, we may see the long maturity rates move up.
3. Foreign governments may be forced to sell or may voluntarily diversify - Taking cue from Warren Buffett, government debt is expensive right now (rates are low). Some countries may find it necessary to sell their treasuries to raise cash for local stimulus, while others may be looking to diversify at a time of a strong dollar and attractive exit prices. Others, such as China, may be looking to add less long term treasuries to a portfolio already centered on U.S. debt.
4. Risks exist to both the sovereign rating of the U.S. and the stability of the currency - In my opinion, the biggest factor driving the steepness of the yield curve is the financial health of America's balance sheet. Although many are searching for ANY yield right now, as small as it may be, they are looking at the front end of the curve as further down the line carries increasing risks.

What I don't see is inflation. With yields under 5% and risks such as losing AAA sovereign rating, over supply, concentrated supply and currency risk, I don't see much room left to compensate investors for inflation risks as well. In fact, assuming these bond markets are mostly efficient, which they are, TIPS are pricing in no inflation bordering deflation for the next several years.

Shorting Treasuries vs Buying Gold

I know that I have been talking about gold too much lately, but I had to make this comparison. Simply buying gold presents lots of basis risk assuming that gold is being bought to hedge inflation due to the massive budget deficit. I am short treasuries through an ETF symbol TBT which is ultrashort 20+year treasuries. With Volcker so close to Obama, should inflation suddenly creep up on us as the gold bugs warn, then I expect to see rates move up quickly and treasuries drop in price quickly. Should they fund it with more debt in the short term, rates could go up as well to reflect the over supply. Should they print money to pay down their debt fast, there will be a stampede out of all treasuries (probably the reason that they wouldn't do that).

If you follow my blog, you know that I see gold as being overvalued. To a large extent I see treasuries as being overvalued as well, although they could strengthen further if the target rate is reduced to 0%. I look at this from the perspective of an investment strategist and think: do I buy expensive gold or short expensive treasuries to play a very similar hypothesis? - I choose shorting treasuries (20-year+). Although in theory gold would rise, in reality gold is already pricing in more sovereign risk than treasuries, which are trading at very low historical yields reflecting very little sovereign risk.

Disclosure: Author owns TBT related bonds.

Comments

[fjpenney]

This analysis gives a completely different take on the slope of the yield curve than that presented by Bespoke Investment Group in their Seeking Alpha article two days ago. Their article was not as in depth as this one. Time will tell which analysis proves to be correct but it certainly doesn't feel like the economy is about to improve and the stock markets move upward.

2008 Nov 19 08:14 AM

[cyclingscholar]

Very good article. Something has to give. The increase in Tbond prices has a flight-to-quality aspect about it, when it appears that the worst of the liqudiity crisis has passed. In that case the safety of Tbonds is a premium not worth paying, and they should sell off sharply.

Or else the liquidity crisis is about to resume with a vengeance....

cyclingscholar

2008 Nov 19 10:27 AM

[Doris Salzmann]

Correct me if I am wrong, but don't you have to pay double the dividends in a double short ETF like TBT? Will these dividends relate to the interest rates at time of purchase or change with interest rates?
Please, excuse this very basic question. I am new to bonds and until recently didn't even know that dividends would have to be payed out of the short ETFs.

2008 Nov 20 02:06 PM