Bond Market Smells a Rat: Inflation. So the Fed seems OK with rising long-term Treasury yields.
By Wolf Richter for WOLF STREET.
The bond market smells a rat, but the mortgage market and the high-yield bond market are holding their nose and plowing forward: The 10-year Treasury yield rose to 1.21% on Friday, the highest since February 26, when markets began their gyrations. This yield has more than doubled (+133%) from the historic low of 0.52% on August 4.
In early August, Wall Street hype mongers were still out there pushing the meme that the 10-year yield would fall below zero and be negative for all years to come, in order to entice buyers to buy at that minuscule yield. And had the yield dropped below zero, those buyers would have made some money – especially those with highly leveraged bets.
Alas, when potential buyers need to be enticed with a lower price, which is what began to happen after August 4, the price of that bond falls and therefore the yield rises, and those who’d bought at the lower yields are losing money. For example, at the most basic unleveraged level, the iShares Treasury Bond ETF [TLT], which tracks Treasury securities with at least 20 years of maturity left, fell 1.24% on Friday and is down 14.3% since August 4.
The 30-year yield rose 7 basis points on Friday to 2.01%, the highest since February 19. The yield has more than doubled from 0.99% on March 9.
The Fed has the short-term Treasury yield locked down near zero, via its various interest rate mechanisms and Treasury purchases. Even the yield of the 2-year note is near zero, at 0.109%. With the short end near zero, and the yield at the longer end rising, the yield curve has steepened.
One of the classic measures of the yield curve, the difference between the 2-year yield and the 10-year yield, widened to 1.1 percentage points on Friday, the widest spread since April 2017. That spread had turned negative briefly in August 2019, when the yield curve “inverted” as the 10-year yield dropped below the 2-year yield.
Mortgage rates went in the opposite direction, but are now having second thoughts.
The average 30-year fixed-rate mortgage rate, which generally tracks the 10-year yield, continued dropping after August 4, even as the 10-year Treasury yield was rising. Finally, in early January, it stopped dropping when it hit 2.65%, and has since ticked up a tiny bit. According to data from Freddy Mac, the weekly average as of February 11 was 2.73%.
This chart of the mortgage rate as per Freddie Mac (blue line) and the 10-year Treasury yield shows the disconnect since last summer. But as weekly numbers, they lack the movements over the past two days, when both have risen:
But Junk bond yields continue to drop from record low to record low.
The average yield per the ICE BofA US High Yield Index, which tracks US-issued junk bonds across the high-yield spectrum, dropped to 4.09%, the lowest in history, going from new low to the next new low, documenting every day the fabulous bubble going on in the riskiest end of the credit markets.
At the upper end of the junk bond markets, the average yield of bonds in the “BB” category (my cheat sheet of corporate bond ratings), fell to 3.19%, according to the ICE BofA BB US High Yield Index, having fallen from historic low to historic low. That’s what 10-year Treasury securities were yielding in October 2018.
But at the upper end of investment grade, average AA-rated corporate bonds have been slowly following the trend set by Treasury securities, but at a much slower pace, having risen just 25 basis points since August 4.
The Fed appears to be OK with rising long-term Treasury yields. Multiple Fed officials have said that if the higher long-term yields are a sign of rising inflation expectations and economic growth – rather than financial stress – they are welcome. And so they’re allowed to rise.
For the Fed, these increases in the long-term Treasury yields and the continued declines in junk bond yields and the near-record-low mortgage rates are a soothing combination, speaking of inflation and not financial stress.
If the spread of junk bonds and mortgage rates to Treasury securities were to blow out suddenly, that would be a sign of financial stress, and might be more worrisome for the Fed.
So the rat that the Treasury market is smelling is consumer price inflation. It’s gnawing its way through various layers of the economy. And the Fed has said that it will ignore inflation for a “while,” and that it will welcome an overshoot of inflation. Only when it becomes “unwanted” inflation, as Powell put it without specifying what that means, would the Fed crack down.
So maybe the Fed would crack down when inflation stays above 4% or 5% for a “while?” Once inflation has solidly set in, it’s hard to stop. That’s the rat the Treasury market is smelling, and if you’re sitting on a bond that yields 1.2% for the next 10 years, that’s not a mouthwatering item on the menu.
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