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Making Sense: Why Is The Treasury Yield Curve Flattening?

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Can’t anybody here play this game? ~ Casey Stengel

The legendary manager uttered these words while managing the 1962 New York Mets, a team which lost 120 games. That an expansion team has a terrible record in its inaugural season is not surprising. However, a team which had its fair share of veterans, although aging, was expected to do somewhat better than losing 120 games.
In contrast, the expansion Houston Colt .45s (later Astros) lost just 96 games in its inaugural season of 1962. That the 1962 Mets, with former All-stars, such as Gil Hodges, Richie Ashburn and Gus Bell, along with future All-star, Felix Mantilla, were expected to have a better season than 40-120. I find myself asking the same question as Casey, regarding the bond market.  
 
In today’s Wall Street Journal, journalist, Min Zeng, discussed a “redux” of “Greenspan’s Conundrum.” The article begins with:
 
“The U.S. bond market is defying the Federal Reserve again.”
 
This statement alludes to the fact that long-term rates have declined, even as the Fed has raised the Fed Funds Rate four times, since December 2015.
United States Treasury Bonds

That’s not how rates work

Permit me to make something clear:
 
The Fed’s interest rate/Fed Funds Rate policy does not directly impact rates on the long end of the yield curve. Inflation pressures and expectations are the main influences on long-term interest rates. In fact, because monetary policy tightening is inherently anti-inflationary and, therefore, can have an inverse effect on the long end of the curve, where long rates fall as short-term rates rise.
This is precisely what has occurred. Curve flattening, where short-term rates rise and long-term rates decline, tends to occur late in economic expansions. Today, we are seeing lending activity falter. Job growth is slowing. Wage growth is stuck in the low-2.0% area and consumer spending is not sufficiently strong to create enough demand to overcome the disinflationary impact from technology. 
 
In my opinion, the Fed is not hiking because the economy or inflation are overheating. The Fed is tightening because it realizes that the current economic expansion cycle is in its latter stages and it wants monetary policy ammunition to combat the next economic slowdown. The Fed is also concerned with frothy conditions in areas of the capital markets. During an interview session in London, yesterday, Fed Chair Yellen opined that equity asset values are “rich” at the present time.
That appears to be, at least somewhat, true. However, if equity asset values are at least somewhat rich, high yield debt valuations appear downright luscious. I mean; one needs an insulin shot just to look at high yield debt market levels. Thus, the Fed could continue to renormalize monetary policy, even with Core PCE below its 2.0% target, if Fed officials view overheated asset values as a threat to the economy. 
 
The way I see it is: It is going to be difficult for long-term interest rates to surge higher without stronger inflation pressures. Fed policy “renormalization” runs counter to the stronger inflation story. 
 
What about Greenspan’s Conundrum during the Housing Bubble? I don’t buy the conundrum story. Mr. Greenspan knew precisely why long rates were not rising. The causes of stubbornly-contained long-term interest rates/bond yields were:
 
1)    Contained Inflation
2)    Strong demographic demand for bonds
3)    Foreign central banks were buying long-dated USTs for currency purposes, etc.
4)    Fed tightening is inherently disinflationary. The Fed poured gasoline on the low long rate fire started by the first three catalysts.
 
I’m, sorry folks. You will never convince me that Alan Greenspan, a man who has probably forgotten more about the bond market and interest rates than most experts will ever know, did not understand what was happening. I believe Mr. Greenspan was keenly aware of what was happening. However, in order to maintain Fed credibility, he could not come out and tell the markets that the Fed was essentially impotent in managing lending and bond market conditions.
 
 Many critics blame the Fed for not raising rates soon enough to prevent the housing bubble. The truth is that there were forces out of the Fed’s control which drove the housing bubble, this included mortgage securitization which kept lending capital flowing, even as the curve inverted, in 2006, when prudent bankers where slowing lending activity. I wish I could post my “Making Sense” archived from my Citigroup days, because I discussed all this while it was happening.

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About Thomas Byrne
Thomas Byrne has achieved a 26-year career in financial services, 23 of which have been spent in the fixed income market sector. In his role as Director of Fixed Income for Wealth Strategies & Management LLC., Byrne is responsible for providing strategic analysis and portfolio management to private clients and institutions, in addition to offering strategic advisory services to other financial services organizations. Byrne's areas of expertise include trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt, and convertible bonds. Additionally, Byrne provides analysis, strategy, and commentary within the fixed income market. Prior to joining WS&M, Byrne worked as Director in the Taxable Fixed Income Department of Citigroup, Inc., in addition to predecessor companies in New York, NY.
Twitter: @Bond_Squad
E-mail: Thomas.byrne@wsandm.com

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Thomas Byrne

Thomas Byrne serves ad the Director of Fixed Income for Wealth Strategies Management LLC. Thomas brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets. High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
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