March 3, 2006
THE CONFIDENCE GAME
The confidence that has recently enveloped the Treasury market seems to be evaporating, or so one could reason in light of yesterday's jump in the yield on the benchmark 10-year Note.
As of Thursday's close, the 10-year yield was 4.64%, up sharply from Wednesday's 4.59%. At one point yesterday, the yield was nearly 4.67%. As a result, the 10-year yield is near its previous highs of late October, when 4.68% was briefly touched.
What's going on? There's no shortage of theories circulating, ranging from the usual suspects to some fresh catalysts for anxiety. To be sure, some pundits are still predicting an economic slowdown, if not worse, including the estimable Economic Cycle Research Institute. But those with the opposite view have the upper hand at the moment. Indeed, adding to the momentum among the latter is yesterday's 25-basis-point hike in the European Central Bank's key rate to 2.5%. Warning of inflation risks in 2007, ECB head Jean-Claude Trichet explained that he was intent on nipping the threat in the bud. Did the Europeans frighten traders in the Treasury market?
Another candidate for thinking that higher rates are still coming is the realization that the federal government's deficits may be deeper in red ink than previously thought. There's much debate about whether deficits and higher rates are truly linked, but expectations of bigger government debts can still move bond prices. On that note, Govexec.com, the website for Government Executive magazine, yesterday reported that the Treasury Department sent a "little-noticed" study to congressional leaders "that paints a bleaker picture of the nation's finances than is widely accepted and is beginning to attract attention as lawmakers prepare for election-year budget battles."
Meanwhile, Treasury Secretary John Snow told the San Francisco Chronicle that wages are at a "tipping point." He predicted that they'll start rising. "For the last three months or so, real wages are up something like 1.5, 1.6 percent," he said.
Cabinet members like to speak of such things, and are forever suggesting that sunnier days are just around the corner for the masses. But at this particular juncture, investors might think twice before dismissing Snow's outlook. The economy, after all, has been showing signs of strength recently, as we noted yesterday. Adding to the optimism is yesterday's update on weekly jobless claims: the advance figure for seasonally adjusted initial claims was 294,000 for the week through February 25, the Labor Department reported on Thursday. That's the seventh straight week of a below-300,000 reading, convincing many economists that the labor market is clearly growing.
One might then wonder if the inverted yield curve in Treasuries is about to reverse course and return to something approximating a more normal state, namely, higher yields in longer maturities. An inverted yield curve often signals an approaching recession, but for the moment it's harder to make that prediction, at least by considering the limited sample of data that's come across our desk. If in fact the economy is destined to keep chugging along for the foreseeable future, the inverted curve at the moment in Treasuries may be headed for change.
Traders of government securities seem to have no less on their minds. In fact, if you look at corporate bonds, the yield curve is upward sloping, which is to say there's no inversion, as per a newly minted chart from Cumberland Advisors.
Why is the corporate bond market priced in anticipation of economic growth while the Treasury market seems to expect the opposite? Add it to the ever-lengthening list of mysteries that inhabit the state of finances in the 21st century.
Definitive answers may be elusive, but there's no shortage of theories. One that caught our eye was dispensed yesterday by David Kotok, Cumberland's chief investment officer. In a letter to clients, he observed that not all yield curves are inverted, the Treasury's being the notable exception. One potential reason, Kotok opines, is that the government bond market is "distorted" by foreign investors, such as Asian central banks sitting on large trade surpluses looking for a home, courtesy of the United States penchant for imports.
But if Kotok is quick to come up with an explanation, he's less reluctant to rush to judgment when it comes to deploying capital. "All this means that the interest rate outlook is very unclear," he wrote yesterday. "There may be still higher interest rates in the future as the Fed raises the short term rate. We believe that is the most likely outcome. But how much higher is very unclear. Cumberland’s managed bond portfolios continue to have a defensive bias."
Posted by jp at March 3, 2006 9:32 AM
I did a quick review of the last few times that the 10-year treasury went for a ride like it did this past Thursday and Friday.
The results are somewhat comforting (although History does not predict the Future...).
The Mortgage Reports
Posted by: Dan Green at March 5, 2006 5:05 PM