This Crazy Bond Market

by: John M. Mason


The bond market has really bounced around over the past four months, reflecting changing expectations for the economy and inflation due to Trump policy changes.

The term structure of interest rates is currently flatter than it has been for years, which some analysts argue means that an economic recession is not far off.

However, the current data can be interpreted as indicating that inflation is expected to be higher in the next five years than it will be in the five years following.

The expectation, therefore, is for the current Trump economic policies to raise inflation more rapidly in the 2018-22 period than in the 2023-27 period, with economic growth picking up only slightly throughout.

What’s going on in the bond market?

In the middle of December 2017, I put out a pretty strong statement to watch the bond market in 2018.

My strong statement was prefaced by these words:

“Last year (in 2017), many expected longer-term interest rates to rise, but were surprised by a very calm and drifting bond market.”

“2018 may present a different picture with a possible major tax bill going into effect, one that might jar a relatively ‘lame’ rate of inflation.”

That is, things were building up in the country, economic growth seemed to be picking up, and the government had just passed a tax reform bill that everyone was sure that it was going to increase the deficit, leading to more and more debt outstanding.

By the first of February, I was astounded by what was happening in the bond market and wrote a post expressing my surprise.

I led with an expression of this surprise: “I must admit I was not expecting so much action in the bond market so soon in 2018. But, here we are.”

“The yield on the 10-year US Treasury bond closed above 2.60 percent on January 18 - and stayed there. On January 30, the yield closed above 2.70 percent - and on January 31, the 10-year note closed to yield 2.72.”

“The 2.60 percent level was formerly looked upon at the potential "tipping point" for Treasury yields.”

By the middle of March, some doubt seemed to creep into the picture. The economy maybe was not growing as fast as some thought it would. And, inflation was not picking up as many had expected.

So, here we are at the end of March, and the longer-term yields in the bond market are dropping.

What is going on?

On December 13, 2017, right around the time I wrote my post about watching bond yields in 2017, the yield on the 10-year US Treasury note closed at 2.35 percent.

As mentioned above, the yield flew through the 2.60 percent level and closed the month of January right at 2.70 percent.

On February 21, the yield on the 10-year closed at a near-term peak… 2.94 percent.

In the last week, the yield started to back off. On Thursday, March 22, the 10-year yield dropped to almost 2.81 percent. On Thursday, March 29, the yield fell to 2.74 percent.

One thing that has been highly noticeable the last few days has been the flattening of the yield curve. Thursday, March 29, the yield curve was flatter than it had been for a long time, even below the flatness of the yield curve in the middle of December 2017, when many analysts began calling attention to the flatness.

Concern was raised at that earlier time about whether or not the flatness was a sign that we were nearing an end of the current economic recovery. The bond yield curve has often flattened out and/or become negative just before there occurred an economic downturn.

The response was that the current yield curve was taking its current shape, not because we were nearing an economic downturn, but because the economic stimulus coming from the December tax reform bill was expected to have a near-term positive impact on economic growth and inflation, but it would not be lasting and so the increase in economic growth and the rise in inflation would only be short-lived.

Estimates of inflationary expectations for a 5-year horizon and a 10-year horizon tend to support this viewpoint. Here inflationary expectations are calculated by subtracting the yield on the appropriate maturity Treasury Inflation Protected Securities (TIPS) from the nominal yield for the same maturity note.

Thus on December 13, 2017, inflationary expectations for both the 5-year maturity and the 10-year maturity were the same: 1.83 percent.

By the last week in February and the first week in March, the inflationary expectations built into the 5-year yield moved into the 2.15 percent to 2.20 percent range.

Inflationary expectations for the 10-year horizon came in around 2.10 percent to 2.12 percent.

So, expectations for inflation rose in both horizons, but they increased more in the shorter term, 5-year horizon than they did in the 10-year horizon.

Inflationary expectations have dropped back modestly since early March, but those built into the inflation are still expected to be higher over the 5-year horizon than over the 10-year horizon.

In terms of economic growth, the yields on the different maturities of TIPS in December seemed to indicate that growth is expected to be higher over the 10-year period than just in the 5-year period.

In early March, both TIPS yields had risen by about 20 basis points. The conclusion that one can draw from this is that market participants expect economic growth to increase in the future, but the difference in expectations for the improvement in growth in both the short run from growth over the longer run did not change.

Working with these data, we can conclude that the term structure of interest rates has flattened out because it is expected that economic pressure will be greater on prices in the next 5-year period than it will be over the full 10-year period. In other words, short-term interest rates in the next 5-year period are expected to be higher than short-term interest rates from 6 years to 10 years from now.

This expectation does not include the projection of a recession in its 10-year horizon, just a change in where inflation will be expected.

This seems to be a highly unusual forecast, but given the current data, it is not inconsistent with what seems to be currently built into bond yields.

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.