Thursday, May 8, 2014

5-30 and Bonds; 4 Reasons why Low Long Yields.

Treasury 5-30 yield spread is marginally wider (less than half bp) this morning following a 5 bp spring wider yesterday.  Last Friday, this yield spread fell to 167 bps, last seen in ’09.  Stehn at Goldman Sachs put a good note out yesterday looking at ‘market drivers’ in 2014, differentiating between ‘growth’ and ‘poilcy’ shocks, the former creating like responses in equity and yields while the latter shock having dissimilar impact.  This would suggest that the higher equity prices and lower yields from yesterday were more of a policy shock and that Yellen’s testimony may have influenced.

For guide, at the same time Treasury 5-30 yield spread reached to multi-year lows on Friday, the generic 30 year yield traded to a new low of 3.37% last seen in June.  I would point to four contributors for support of low long yields in the U.S..  First is the current geopolitical unrest in Russia/Ukraine. Second is the Fed buying of securities and expectations for extremely long holding period for portfolio. Third is the lower terminal fed funds (policy rate) rate expectations generated by lower expected maximum equilibrium real growth.  Finally, intermediate-term inflation expectations remain well anchored. 

None of these variables are likely to change anytime soon.  There would need to be a longer series of significantly stronger production, housing and employment numbers to impact expectations for terminal policy rates.  There was a little wiggle in CPI and PPI data last month, but ECI remains well behaved and a blind eye will be directed at any relatively mildly stronger numbers there over next months.  As to the Fed’s portfolio, as the Fed moves toward conclusion of its purchase program, they are likely to provide some guidance as to the likely holding period for their portfolio.  We should expect the next words from the Fed on this matter will not invoke a bearish reaction and they will meet or beat expectations for length of portfolio holding period.  Finally, the progress in Ukraine leaves me believing the situation is not going away anytime soon.  Russia appears to have used the timing of the Olympic Games well.  Having first imposed their will on Crimea, they now appear to have chosen to insight unrest on the Eastern border of Ukraine rather than the West.  Now, any Russian ‘solution’ would be expected to be further East to West annexation at higher Northern latitude. 

To Sum:  The long end is well supported.  The 5yr is prone to impact from improving or ceding expectations for growth and policy changes.  Right now, improving growth is coming too slowly to push 5yr yields higher and Fed policy focus is on slow and steady tapering.  Either very strong or very weak economic numbers will be needed to jar the market, this yield spread and rates in general.  All else equal, we should expect the 5-30 yield spread to flatten as 5yr Treasury yields respond to positive economic data and slow to change policy rhetoric.  Absent a significant heightening of tension in Russia/Ukraine, the risk appears weighted toward positive data surprises.    

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