Implications Of Janet Yellen's Speech And The Action In Treasuries

Includes: IEF, IEI, SPY, TLH
by: DoctoRx


With Janet Yellen's speech on Tuesday, the Fed joined those who worry about the global economy harming the domestic economy.

By openly discussing more QE or another Operation Twist, Chair Yellen accelerated movements in money markets that had been underway for at least a few days.

This article reviews some parts of her speech and analyzes certain implications of price action in money markets that may not have received much attention.

My take-home message is to respect the Fed and the message of money markets and favor a macro cautious approach to the markets.


On Tuesday, Fed Chair Janet Yellen gave a speech that sent prices of assets as discordant as equities, Treasury bonds, junk bonds, precious metals and oil higher. That's quite the hat trick and then some. But the Spock in me, while admiring the power of the Fed, also says that this coordinated set of bull moves represents earthlings being illogical. All these assets "should not" move in the same direction at the same time, especially when two of them, namely equities and Treasuries, are at or near all-time record valuations by various metrics. And gold is hardly cheap, up 5X in 15 years.

When at least one major market moves wrongly in this way, my inner Spock questions whether one of the assets is so illogically priced as to merit a trade or a Seeking Alpha article.

What could Dr. Yellen have said to cause such a reaction?

In large part, she promised/threatened that if the US economy did not do what the Fed wanted, it could cause increases in the size or duration of our holdings of long-term securities... we used them effectively to strengthen the recovery from the Great Recession, and we would do so again if needed.

As most readers will appreciate, increases in the size of the Fed's holdings means a new round of QE. Increasing the duration of the Fed's holdings means something like another round of Operation Twist.

Chair Yellen also spent a good deal of time worrying about weakness in the global economy and what she views as undesired "lowflation" - i.e., insufficiently rapid debasement of the currency.

In the old days before QE and the Fed's excessive concern with the precise level of the stock market (NYSEARCA:SPY), this sort of gloomy talk from the Fed would have pushed risk assets lower. After all, with an economy so weak that after three rounds of full-on QE and almost 6 years of still-ongoing "QE 1.5" (reinvestment of maturing bonds, which is QE pure and simple), and with very large Federal deficits throughout, some might think that there's either something structurally wrong with the US economy or with the policy prescriptions of the government. And they would look at the obvious downgrading of growth prospects from already restrained levels and sensibly not bid equity and oil prices higher.

Indeed, it's possible that the economy could enter an outright recession recognized by the Fed and market participants as such, and stock prices would still not drop, and might rise. If the Fed wants to "go Japanese" and buy stocks with newly created money, who will bet against it?

With all these uncertainties and illogical aspects, it's easier for me to focus on interest rates, which at least have real logic moving them. When inflation drops and nominal GDP drops, then interest rates drop.

And when the yield curve begins doing strange things, I pay attention and explain the potential bearish implications next.

I'll begin with the sudden drop in short-term interest rates to below the targeted Fed Funds rate.

Analysis of the Treasury yield curve - the basic data

As an introduction, while Bloomberg News and other sites provide real-time or nearly real-time reports on Treasury rates, the Treasury itself publishes this data daily. Here is its data:

Date 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr
03/01/16 0.29 0.33 0.50 0.68 0.85 0.98 1.31 1.62 1.83 2.28 2.70
03/02/16 0.28 0.36 0.48 0.67 0.85 1.00 1.34 1.65 1.84 2.27 2.69
03/03/16 0.25 0.28 0.46 0.65 0.85 0.99 1.33 1.63 1.83 2.23 2.65
03/04/16 0.25 0.29 0.47 0.67 0.88 1.04 1.38 1.69 1.88 2.29 2.70
03/07/16 0.27 0.32 0.49 0.67 0.91 1.08 1.42 1.72 1.91 2.30 2.71
03/08/16 0.27 0.29 0.48 0.68 0.88 1.04 1.34 1.64 1.83 2.22 2.63
03/09/16 0.27 0.30 0.47 0.68 0.90 1.07 1.39 1.69 1.90 2.27 2.68
03/10/16 0.27 0.32 0.50 0.69 0.93 1.11 1.45 1.75 1.93 2.29 2.70
03/11/16 0.27 0.33 0.51 0.70 0.97 1.16 1.49 1.79 1.98 2.34 2.75
03/14/16 0.28 0.34 0.52 0.70 0.97 1.15 1.49 1.78 1.97 2.33 2.74
03/15/16 0.29 0.34 0.52 0.71 0.98 1.16 1.50 1.78 1.97 2.33 2.73
03/16/16 0.28 0.31 0.47 0.66 0.87 1.05 1.41 1.72 1.94 2.32 2.73
03/17/16 0.29 0.29 0.47 0.64 0.87 1.04 1.39 1.70 1.91 2.28 2.69
03/18/16 0.27 0.30 0.44 0.62 0.84 1.00 1.34 1.66 1.88 2.26 2.68
03/21/16 0.26 0.31 0.46 0.63 0.87 1.05 1.38 1.70 1.92 2.31 2.72
03/22/16 0.28 0.30 0.46 0.64 0.91 1.08 1.42 1.74 1.94 2.32 2.72
03/23/16 0.27 0.30 0.46 0.64 0.87 1.03 1.37 1.67 1.88 2.25 2.65
03/24/16 0.24 0.30 0.46 0.63 0.89 1.05 1.39 1.70 1.91 2.28 2.67
03/28/16 0.19 0.29 0.49 0.65 0.89 1.04 1.37 1.68 1.89 2.26 2.66
03/29/16 0.18 0.23 0.45 0.63 0.78 0.94 1.29 1.59 1.81 2.20 2.60
Click to enlarge

Tuesday Mar 29, 2016

This dense table shows that by Tuesday, the market incorporated Chair Yellen's "guidance" and drastically dropped short-term interest rates. The 2-year rate dropped from 0.89% to 0.78%, a very large move for this security.

Next, I want to focus on two points, both of which I look on as bearish for the economy and bullish for intermediate and (possibly) longer-term high-quality bonds.

Short-term rates drop below the Fed's target

In December, the Fed increased the Fed Funds rate target from a range of 0-0.25% to 0.25-0.5%. Yet, even by Thursday, the 1-month T-bill had edged to 0.24%. By the end of the day Tuesday, it had dropped to 0.18% and the 3-month bill had dropped to 0.23%. These are anomalous.

Is the market anticipating a "one and done" Fed policy and, more ominously, a retreat back to the prior Fed Funds range?

One wonders. The New York Fed presents results of its survey of dealers and reports that the effective Fed Funds rate as of 3/28 was 0.37%. However, volume of funds traded (LENT) was a minuscule $66 billion. That's a drop in the bucket given the gigantic size of the T-bill market. The overnight rate for money should not be well above the 1- and 3-month rates.

That's one problem for the economy that the numbers have begun to imply.

There's also a more subtle possible second problem for the economy in these data.

The implied yield curve suggests inversion has already begun

Most investors look at the yield curve like this, taken from

In the era of QE, a flat yield curve is almost unthinkable. When the yield curve flattens or inverts, a sign of an economic slowdown or recession has been given. So, looking at the above chart, all appears well in the slope of the yield curve, though the absolute level of interest rates is consistent with a major depression, such as the Great Depression of the US in the 1930s. But for those who care, the slope is at least upward.

However, there is a second-order way of looking at the numbers that may suggest problems in the economy. This technique of yield curve analysis begins with the point that under current financial theory, a true upsloping yield curve is upsloping in all ways. As an example of where this holds true, take the 10-30 year complex. If the 10-year T-bond is at 1.80% and the 30-year is at 2.6%, then if we exclude interest earned on interest payments, taxes and any transaction costs, we can say this:

  • A 10-year bond purchased now will return $118 for every $100 invested, 10 years later.
  • A 30-year bond will return $178 for every 100 invested, 30 years later.
  • The difference in returns is $60. This is what accrues in interest payments in the 20 years from year 10 to year 30. That $60 spread over 20 years represents a 3% annual return (note this is an average and somewhat of an approximation, but this serves well in exemplifying the point).

This 3% is a low return, but it is above the 30-year rate, which is burdened by the very low rate of the 10-year bond. So, everything is logically consistent in this part of the yield curve with the rising rate scenario, even though the absolute interest rates are low.

However, on the short end, we are seeing implied inversion - again, this is a second-order analysis, as it were. From the above Fed table:

  • 3-month rate = 0.23%
  • 6-month rate = 0.45%
  • Implied rate for the "second" 3-month period is about 0.68%.

That expected annual rate of 0.68% is about what would make the decision to buy a 3-month or a 6-month bill a neutral decision, with no reason to favor one or the other. You can lock in 0.45% annualized for six months, or you can lock in only 0.23% for three months and expect 0.68% in the next three months, to make the total return average 0.45% for the entire six months.

In most periods, then, one would expect the one-year T-bill to be at least at 0.68%, probably higher. That's how things were on, for e.g., March 21. Then, the 3-, 6-, and 12-month rates were 0.31%, 0.46%, and 0.63%, respectively. The implied rate for months 4-6 was about 0.61%, which is lower than the 1-year rate.

However, the 1-year T-bill is trading at 0.63%, compared with what I infer to be the neutral 4-6 month rate of 0.68% as shown above.

Using the identical logic, we can look at the 6-month rate of 0.45% and the 12-month rate of 0.63% and infer that the neutral rate for months 7-12 is 0.81%.

However, this implied 0.81% rate for months 7-12 is higher than the 2-year T-note rate of 0.78%.

This sort of yield curve analysis suggests to me that the market is sniffing out curve flattening or a further decline in short-term rates. This would explain the willingness of traders to accept a lower rate on 1-2 year Treasuries than I would expect. I think they are locking yield in for the duration, and these are very smart traders who know, more or less, everything.

It thus looks to me as though between the T-bill rate dropping below the Fed Funds rate for a few days and the implications of the yield curve on the short end, the bond (bill) market is sending a message that I want to heed.

This would suggest that there is downside risk to current economic projections on the Street, perhaps in line with the Atlanta Fed's latest rather dismal Q1 GDPNow nowcast of 0.6% annualized growth in the current quarter:

Evolution of Atlanta Fed GDPNow real GDP forecast

This forecast/nowcast is well below numbers floating around the Street.

All this suggests that some modest capital gains and security of principal could accrue to a commitment to short-to-intermediate term high-quality debt instruments, of which Treasuries are the most liquid.

When I do this sort of analysis, I like to see if the technicals I look at are in gear. At least one of them is, namely the positioning of speculators in the futures complex.

The technical case for short-term securities

Since I now believe the Fed has no good idea of what's coming next in the US and global economy, or what it will do in response, I don't know how to invest along with the Fed. That's one reason to stay short now. It's very different from the QE periods, when money was being forced into risk assets by the Fed's printing press.

Here is the positioning on the 5-year and 2-year Treasuries from FINVIZ:

Click to enlarge

Click to enlarge

As you can see, the speculators hate the short end - at least they did as of the latest reporting period. The green line below the price chart shows the net positioning of commercial hedgers. This is equal and opposite to the positioning of the speculators, whose net positions are the sum of the red and blue lines.

These speculators have generally been wrong on Treasuries for the entire bull market, so I'm comfortable investing against them now.

Additional context - speculators wrong again on their macro views?

If one goes through the net positioning of the speculators on oil, gold and silver via the same website, one sees a marked level of bullishness among speculators. These tend to "herd," especially the large speculators. At least based on futures market positioning in the US markets I have access to, they have been betting in a one-sided manner on the rising short-term rate, rising inflation and rising gold/silver/oil price scenario.

But increasingly, they are looking out of touch with the Fed's reality, which is as accurate as it gets, even if the Fed's forecasts are often useless. When it comes to current conditions, the Fed sees almost all, knows almost all.

Now, short rates have joined the recent downtrend in precious metals and oil.

Thus, there is a coherent story that once again, unfortunately, the seers at the Fed and on the Street may have been overoptimistic about the pace of global growth post GFC.

That has implications for all tradeable assets.

Concluding points - the case for caution

With so much of the world's financial marketplace at extreme interest rates that were thought impossible except for brief periods of crisis, and with central bankers paying what may be an unprecedented amount of attention to day-to-day changes in stock prices, the old rules of investing have temporarily been thrown out the window.

For me, this situation argues for caution while whatever is happening globally evolves further and a more understandable full picture of financial asset prices and their relation to the real economy emerges.

As I see it, the very knowledgeable short-term Treasury market is concerned about the pace of the real economy, and is not concerned one bit about inflation in the short term.

Given that, and given the discordance of that view with rising and highly valued equity prices, rising commodity prices and rising emerging market currencies versus the USD, I think a defensive posture among that part of my assets that's used for trading is appropriate; and this includes taking profits in long-term Treasuries. A lot of "stuff" may be going on now, and there's no need to try to be a hero by trying to predict the future.

If the T-bill markets are correct, the Fed may join the long list of central banks that tried to raise rates since the GFC, and instead, were forced to lower them back to, or below, where they had been.

If that occurs, yield lock-in for several years or longer may come to be desired. Also, some further capital gains potential may be available from an investment in short-to-intermediate high-quality bonds up to perhaps 10 years (or longer) in maturity. Among the liquid names are the iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF) and the shorter-duration iShares 3-7 Year Treasury Bond ETF (NYSEARCA:IEI). A higher yield without going very long term is found in the less liquid iShares 10-20 Year Treasury Bond ETF (NYSEARCA:TLH).

Of course, there are many ETFs and mutual funds in this space, and individual securities are readily available to be purchased.

To summarize, the wise old saying is to not fight the Fed and the tape, especially when they are in sync with each other. For now, the Fed and the bond tape are in bearish sync. The SPY, at 24X TTM P/E, can vote as it wishes. My vote is to respect the Fed and the message of the T-bill market, and focus on capital preservation.

Thanks for reading. I look forward to any comments.

Disclosure: I am/we are long IEF,TLH.

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.

Additional disclosure: Not investment advice. I am not an investment adviser.