After Yellen: Explaining The Recent Trend In U.S. Treasury Yields

Includes: TBF, TBT, TLO, TLT, TMV
by: Evariste Lefeuvre

The flattening of the US curve was widely anticipated for 2014, but only after the end of the taper, when the markets would shift focus to the timing of the first rate hike. Since reaching a cyclical peak of 265 bps in early 2014, the slope has fallen by 20pbs. This move has been driven by the long end but, as can be seen below (yellow squares), the short end has moved in sync:

Both the money market curve (Eurodollar contracts spread between the first nearby and December 2012 - EDZ6) and the US Treasury yields are moving within the upper and lower bracket of end-of-2016 Fed funds target expectations within the FOMC member forecast spectrum. So far, no jump has been reported, suggesting that the Fed has managed to steer the curve through forward guidance.

The current reading suggests that the Fed will hike when the unemployment rate is well below the 6.5% threshold. (The range of end-of-2016 FOMC participants' assessments of appropriate policy is so wide that it could justify - barring a regime switch of "jump" of the curve - US Treasury yields in a bracket of [2.25%/3.5%]).

Yet, the ongoing smooth tapering should have called for a bear steepening. Why didn't that happen?

  1. Revised Fed Policy

Of course, the primary usual suspect should be the expectation of a pause in the pace of reduction of Fed's bond purchases. Yet, this option has been raised by no Fed member recently and the consensus regarding the continuity of the consensus has not changed sufficiently to justify such a fall in long term rates. During her Testimony before the Congress, Janet Yellen suggested that there could be a pause in taper should there be a "significant" change in the outlook. I bet the economic shock would have to be quite stronger than the recent softening of economic data.

  1. Bearish stock sentiment?

10-year US Treasury yields have reacted to the VIX recently, but as shown on the chart below, the relationship is not linear as yields take much more time to mean-revert (if they ever do) - otherwise UST yield should be closer to 2.9% than today's 2.68%.

As can be seen on the second chart, the link between VIX and UST yield has been pretty weak over the last year, which is unsurprising in a period of monetary policy uncertainty.

  1. Economic news flow

Beyond risk aversion, which remained low by historical standards (and not pervasive), variations of the slope of the 2/10 curve have re-correlated with the economic news flow. The recent deceleration in US growth momentum can explain the bear flattening of the US curve.

The muted reaction of UST 10-year yields to the sharp fall of the ISM recently reflects the dubious treatment of seasonality by data providers, not a weakening of the link between the news flow and long term rates (actually, in a period of monetary policy tightening the link should strengthen as the Fed is more and more focusing on the economic news flow).

  1. Emerging Markets Crisis

The first leg of the EM crisis (May/October 2013) was clearly related to the sharp hike in US Treasury yields. As can be seen below, correlation of EM currencies with UST yields turned highly positive. As the current turmoil is related to EM domestic issues, rather than Fed-induced spillover, the correlation between US yields and daily currency changes is not significant, suggesting that US Treasury yields are not driven by strong safe haven flows.

Comparing the long term rates to MSCI Emerging stocks, we note that when rates jumped following the taper announcement, stocks collapsed. Traditional safe haven flows would imply a fall in EM stocks coupled with lower US yields. As can be seen, both series have only recently and mildly recoupled, which would suggests that if the relationship is back to normal, there is scant evidence of huge safe haven flows.

Bottom line: US Treasury yields have been mainly reacting to the US economic news flow and co-determined by a very bearish view of the US economy over a two-year horizon. Interestingly, only a tiny part is explained by safe haven flow, in spite of the EM crisis.

The Fed is managing a mild tightening in a decelerating economy. For any investor willing to remain long US Treasuries (NYSEARCA:TLO), I would recommend focusing mostly on the US economic news flow, not on any external strain, as I don't expect any significant safe haven related purchases of US Treasuries in the near future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.