The Most Important Interest Rate Risk: Number 2

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The yields on longer-term bonds have risen since the recent presidential election and it is important to understand the reasons why these rates are increasing.

The first jump in these yields seem to come as market participants raised expectations for higher future rates of inflation caused by the fiscal programs proposed by the president-elect.

The most recent jump in the longer-term yields appears to be coming from "safe haven" money leaving the part of the market including the Treasury Inflation Protected securities.

On November 1, I wrote about the risk embodied in U. S. Government bond yields resulting from the flight of "safe haven" money from elsewhere in the world into the Treasury bond market.

This was a flow of money that helped, earlier in the year, to propel the yields on U. S. Treasury Inflation Protected securities (TIPs) to zero or below.

At the time of writing that post, the yield on the 5-year TIPs was around -0.450 percent, and the yield on the 10-year TIPs was just above zero.

As I wrote in the post,

"…in late January and early February (2016), the yields on the TIPs began to plummet.

By the first of March, the yield on the 5-year TIPs dropped below zero.

Early in July, the yield on the 10-year TIPs dropped below zero."

The drop in the yields on TIPs was due to foreign money flowing into the United States.

My concern has been that these funds were relatively volatile and could leave the U. S. as the rest of the world seemed to become relatively more secure, or the United States could become relatively more unsettled. This, I believed was the basis for the very low yields on the TIPs securities.

With the election of Donald Trump as president-elect, not only did the stock market take off, but the yields on longer-term bonds rise. I wrote about these moves on November 11.

The primary shift in longer-term Treasury yields came due to a shift in inflationary expectations. One of the catalysts for the rising interest rates and the rising stock market was the belief that Trump's fiscal policy would stimulate the economy, causing inflation to increase.

Using the spread between the nominal yield on U. S. Treasury securities and the yield on TIPs of a similar maturity to estimate inflationary expectations, we saw inflationary expectations at the 10-year maturity rise from around 1.70 percent in late October, to around at just above 1.94 percent after the election.

Note that the 1.94 percent expectation is just below the long-term inflation target of the Federal Reserve. Inflationary expectations for the 5-year horizon rose from around 1.70 in late October to just under 1.90 percent in recent trading.

So, there was a surge in the market's expectations of inflation after the Trump election. The interesting thing was that the yields on the TIPs did not change dramatically right away. It was only several trading days after the election that the yields on the TIPs began to move.

Since that time, however, the yield on the 5-year TIPs rose from about -0.44 percent to around zero. The yield on the 10-year TIPs rose from about zero to over 0.44 percent.

One might also note that these latter funds movements also coincided with a move in some comparative international longer-term rates. For example, toward the latter part of October, the yield on the 10-year German bund was around zero. At the time of the rise in the yield on U.S. TIPs, the yield on this German security rose to over 0.31 percent, the first time it has really been in positive territory since early March 2016.

The yield on the 10-year Japanese government bond, which was in negative territory in late October, became positive around the time of the move in U. S. yields and German yields. The Japanese yield had been in negative territory since the middle of February.

Thus, if the movement in U. S. yields seems to be caused by a "Trump effect" then one could say that this "Trump effect" was transmitted throughout world financial markets.

So, the rise in nominal Treasury yields since the presidential election resulted, first, from a relatively small rise in inflationary expectations, but the rest of the rise, the larger part of the increase, came about as monies left the "safe haven" of U. S. Treasury securities and went elsewhere in the world.

This movement of funds, to me, is significant and continues to bear watching. There is still a lot of this "safe haven" money in U. S Treasury bonds, but more funds could move in the future, resulting in further increases in longer-term yields.

My current estimate is that the yield on the 10-year TIPs, as reported in my November 1 post mentioned above, should be in the 1.25 percent to 1.50 percent rate. If this is true, then that would mean that there is still a lot of "safe haven" money in the United States, which could leave the U. S. at any time.

I continue to believe that this market needs to be watched carefully and I will do my best to contribute to the analysis of what is happening here.

Disclosure: I/we 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.