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business newsReal Treasury Yields: Like "The Gathering" From 'Highlander,' Only Worse
By
Professor Pinch
Feb 03, 2012 10:20 am
As the Fed tries to stoke economic growth, its unconventional policies are leaving unintended consequences everywhere. But their impacts are long-range and hard-hitting.
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“There can only be one.”
-Highlander
Indeed. Connor MacLeod had to fight his way through time and men to receive The Prize in that one epic tournament of immortals in New York. The sword fights, the beheadings, the Queen soundtrack. All of it was glorious in its own unique way.
Why do I bring this up? Because like a date with destiny, the Fed seems to be bound and determined to euthanize the yield curve. David Schawel (@DavidSchawel on Twitter) wrote a smart post a couple of days ago which got some attention, and rightfully so. Because one of the things that seems to be getting lost in all of those charts showing declining (or is it decaying?) Treasury yields has been the underlying drivers for the yield decline.
And as David's post points out, the only point on the yield curve that has a positive real yield (which is calculated as the difference between nominal and breakeven yields) now is the 30-year bond. The very longest of the long-end Treasuries. All other points on the curve have a negative real yield.
What does this mean? It means that not only is there no premium for owning Treasuries over a basket of stuff, but essentially you're better off owning stuff than Treasuries almost 30 years out. This chart from a recent CME Group (CME) paper puts the bull flattening we've seen in context, to show how much yields have come in so that now one point, the 30-year, is the last point on the yield curve with a positive real yield:
Now that David let the cat out of the bag about negative real yields, how long will the cat be scurrying about?
To answer that, I started looking for forecasts that I knew of. Kamakura Corporation (@KamakuraCo) routinely posts its own yield curve forecasts, and their latest one sees 10-year yields rising to about 3.62%, or roughly where they were a year ago. That rate rise is projected to occur over the next 10 years. To call this rate rise a slow boat to China is both hilarious and ironic, since the Chinese have been somewhat vocal over the past few years about deteriorating yields. And a rate rise will probably hurt their existing Treasury holdings more than the extra yields they will get from higher coupons. As for the rate forecast itself, if you want to know more about Kamakura's interest rate forecasting process, I'd encourage you to look at the documentation they provide on their website.
But that's only part of what they discuss in their forecasts. They also touch on the issue of negative spreads between 30-year Treasuries and 30-year interest rate swaps. It's not an apples to apples comparison between Treasuries and break-even yields, but if I were to guess, I believe the negative real yields and the negative swap spreads are related. At any rate, they point to a blurring of credit quality between financial institutions and the US government in the wake of the credit crunch of '08.
But that's not the only explanation for the phenomena we've been seeing. A while back, Minyanville contributor Fil Zucchi talked about the rush to refinance by corporates, and the resulting fixed for floating payment swaps they executed (see How to Interpret Negative Treasury Swap Spreads). I'm not smart enough to determine if one explanation is more correct than the other, but I don't think the Fed knows either. Either way, unintended consequences strike again.
But the other thing that folks need to keep in mind is what alternatives are left for gaining yield. How will investors react to this? Schawel touches on it here (emphasis, mine):
The implications are long term in nature; many institutions are funding these assets with short term floating rate liabilities. This is all well and good if we stay at zero -- however locking in fixed long term assets could be perilous in the future. There are no easy answers out there, and any solution will result in risk whether it be interest rate risk, credit risk, and/or earnings repricing risk.
In short, the Fed is encouraging more of the behavior that started the whole credit crisis in the first place. It is a well-known fact that shadow bank entities were engaging in the same “fund short, lend long” strategy that Schawel is talking about here in the lead up to the credit crisis and the fall of '08. So the Fed's strategy to encourage growth involves pushing investors and others further and further out on the risk curve. What happens when they draw a line in the sand and refuse? We may be reaching such a precipice.
And the Fed doesn't have any more room to ease rates again, because short-term rates are near zero. All they can do is jawbone a rate hike further and further out into the future or offer to buy more bonds. And we already know where that tactic takes us. It takes us to Japan, circa 1989. Domo arigato, Mr. Chairman.
As for the 30-year and its positive real yield, I'm anxious to see how long it will stay that way. And I'm sure Mr. Schawel is, too.
Twitter: @japhychron
-Highlander
Indeed. Connor MacLeod had to fight his way through time and men to receive The Prize in that one epic tournament of immortals in New York. The sword fights, the beheadings, the Queen soundtrack. All of it was glorious in its own unique way.
Why do I bring this up? Because like a date with destiny, the Fed seems to be bound and determined to euthanize the yield curve. David Schawel (@DavidSchawel on Twitter) wrote a smart post a couple of days ago which got some attention, and rightfully so. Because one of the things that seems to be getting lost in all of those charts showing declining (or is it decaying?) Treasury yields has been the underlying drivers for the yield decline.
And as David's post points out, the only point on the yield curve that has a positive real yield (which is calculated as the difference between nominal and breakeven yields) now is the 30-year bond. The very longest of the long-end Treasuries. All other points on the curve have a negative real yield.
What does this mean? It means that not only is there no premium for owning Treasuries over a basket of stuff, but essentially you're better off owning stuff than Treasuries almost 30 years out. This chart from a recent CME Group (CME) paper puts the bull flattening we've seen in context, to show how much yields have come in so that now one point, the 30-year, is the last point on the yield curve with a positive real yield:
Now that David let the cat out of the bag about negative real yields, how long will the cat be scurrying about?
To answer that, I started looking for forecasts that I knew of. Kamakura Corporation (@KamakuraCo) routinely posts its own yield curve forecasts, and their latest one sees 10-year yields rising to about 3.62%, or roughly where they were a year ago. That rate rise is projected to occur over the next 10 years. To call this rate rise a slow boat to China is both hilarious and ironic, since the Chinese have been somewhat vocal over the past few years about deteriorating yields. And a rate rise will probably hurt their existing Treasury holdings more than the extra yields they will get from higher coupons. As for the rate forecast itself, if you want to know more about Kamakura's interest rate forecasting process, I'd encourage you to look at the documentation they provide on their website.
But that's only part of what they discuss in their forecasts. They also touch on the issue of negative spreads between 30-year Treasuries and 30-year interest rate swaps. It's not an apples to apples comparison between Treasuries and break-even yields, but if I were to guess, I believe the negative real yields and the negative swap spreads are related. At any rate, they point to a blurring of credit quality between financial institutions and the US government in the wake of the credit crunch of '08.
But that's not the only explanation for the phenomena we've been seeing. A while back, Minyanville contributor Fil Zucchi talked about the rush to refinance by corporates, and the resulting fixed for floating payment swaps they executed (see How to Interpret Negative Treasury Swap Spreads). I'm not smart enough to determine if one explanation is more correct than the other, but I don't think the Fed knows either. Either way, unintended consequences strike again.
But the other thing that folks need to keep in mind is what alternatives are left for gaining yield. How will investors react to this? Schawel touches on it here (emphasis, mine):
The implications are long term in nature; many institutions are funding these assets with short term floating rate liabilities. This is all well and good if we stay at zero -- however locking in fixed long term assets could be perilous in the future. There are no easy answers out there, and any solution will result in risk whether it be interest rate risk, credit risk, and/or earnings repricing risk.
In short, the Fed is encouraging more of the behavior that started the whole credit crisis in the first place. It is a well-known fact that shadow bank entities were engaging in the same “fund short, lend long” strategy that Schawel is talking about here in the lead up to the credit crisis and the fall of '08. So the Fed's strategy to encourage growth involves pushing investors and others further and further out on the risk curve. What happens when they draw a line in the sand and refuse? We may be reaching such a precipice.
And the Fed doesn't have any more room to ease rates again, because short-term rates are near zero. All they can do is jawbone a rate hike further and further out into the future or offer to buy more bonds. And we already know where that tactic takes us. It takes us to Japan, circa 1989. Domo arigato, Mr. Chairman.
As for the 30-year and its positive real yield, I'm anxious to see how long it will stay that way. And I'm sure Mr. Schawel is, too.
Twitter: @japhychron
No positions in stocks mentioned.
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