Flat U.S. Yield Curve Is All About Momentum and Algos
(Bloomberg View) -- It's hard enough to get the public to pay much attention to the market for U.S. Treasuries even in the best of times. And with volatility recently falling to a record low, mom and pop don’t need to check their IRA’s to see what their bond funds are doing. Treasury 10-year yields are trading at 2.32 percent, right at their average for the year. But don't be fooled by the seeming stability, for underneath this placid façade lies a powerful trend.
The yield curve, or difference between short- and long-term bond rates, has been flattening like a pancake, with the pace accelerating the past few weeks and garnering a wave of media attention. Yields on 10-year Treasury notes have fallen to within 69 basis points of two-year yields from about 125 basis points at the start of the year. The last time the gap was this narrow was 2007. This is an important development because a narrower yield curve has historically been associated with a slowing economy. But what's baffling to many is that there are no signs of economic weakness, with growth coming in at a 3 percent pace and the Federal Reserve raising interest rates too slowly to threaten the expansion.
The shrinking yield curve is both rational and a complete mystery. Yields on two-year notes have edged higher in recent weeks, to about 1.63 percent, which is the highest in a decade. That's the part of the equation that makes sense because the Fed has made clear its intent to continue raising rates, including a hike next month to a range of 1.25 percent to 1.50 percent, from the current 1 percent to 1.25 percent. Simple math dictates that short-term bond yields are held captive by the overnight rate, and the money markets show traders are placing the odds of rate increase next month at 90 percent.
While the short-end of the yield curve can easily be explained, it's the long end that is the mystery. The 4-basis-point increase in two-year yields in recent weeks has been overwhelmed by the big 11-basis-point drop in 10-year yields. The move in 30-year bonds is even more remarkable, as yields have dropped 18 basis points to 2.79 percent. That translates into a 3 ½-point increase in prices, or $35 per $1,000 face amount. What makes the move unusual is that there is little evidence that demand is being driven by foreign investors, which has usually been the case in recent history whenever yields fall.
Instead, the movements suggest the drop in longer-term yields is related to action in the futures market, specifically the 20-year contract. The nature of the futures market means it's hard to pin responsibility on any one group of traders. In this day and age of high-speed digital and algorithmic trading, though, large players can move huge positions quickly and anonymously, avoiding the large dealer banks that used to control the flows in the cash markets. The consensus is that there are a number of futures-only leveraged players driving the gains in longer maturities, particularly risk-parity funds that add to long positions as volatility falls.
Also, many futures-focused hedge funds are trend followers, looking to profit from sustained moves in the market. As such, the flattening yield curve is forcing them to add to existing positions, as many systemic models get more aggressive the more a trade works in their favor. Plus, there are signs that demand is coming from pension funds, particularly for long-dated Treasury zero coupon bonds. Finally, the U.S. Treasury Department has indicated the huge increases in government debt coming will initially be skewed toward shorter maturities, which is helping to alleviate concern about increased supply in longer maturities.
Although the pressure on shorter-term maturities coming from the Fed and the robust economy should persist, the flows holding up the long end of the yield curve have less of a fundamental basis and could turn around very easily, catching a growing crowd on the wrong side of the flattener trade. Sticking with the parts of the curve where the Fed is in charge is the safer play. Today’s auction of 30-year bonds by the Treasury should provide a sense of the depth of the demand for longer-term bonds.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Scott Dorf is a managing director at Amherst Pierpont Securities. He has been selling and trading U.S. Treasuries for more than 30 years.
To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.
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