“History may not repeat itself but it does rhyme.”
The veracity of that aphorism, often attributed to Mark Twain, was bolstered by the Treasury market Tuesday as the 10-year Treasury note yield tested 3 percent, a level not attained since early 2014.
That would have been a repeat of history, but the credit market now differs greatly from that of four years ago. Here’s where the rhyming comes in. The yield curve now is flatter—very much so—than it was in 2014. The yield spread between 2-year and 10-year government paper is now just 49 basis points (0.49 percent). Four years ago, it was 258 basis points.
The 10-year T-note is the fulcrum for the credit market now. You can see in the chart below how the yields in front of the 10-year have been lifted while longer rates have slumped.
U.S. Treasury Yield Curve
Several factors contribute to the 10-year rate rise and the curve flattening. First, the Federal Reserve is throttling back its accommodation. The massive bond-buying program initiated by the Fed in the wake of the 2008-09 financial crisis was leaden footed on the short end of the curve. Since that buying started tapering (and central bank started to actively snug up the federal funds rate), yields on the left have floated higher.
The second factor is inflationary expectations. Four years ago, the 10-year breakeven inflation rate, was 2.29 percent. The BEI is a threshold inflation rate that justifies the purchase of an inflation-protected security over conventional paper. The rate signals the market’s expectation for future inflation.
Today, the 10-year BEI is 2.18 percent. From this, you’d think inflationary expectations have eased since 2014. They have indeed, but they’re now on the rise again. You can see this depicted in the chart below which puts up the 10-year BEI against the current annual inflation rate as measured by the Consumer Price Index.
Inflation Now and Expectations for the Future
Another force at work on the curve is the expectation of further Fed rate hikes. It’s clear that investors and traders envisage more. After all, the Fed’s not just telegraphing its intentions, it’s televising them in ultra-high definition.
So, Fed tightening is operating on the short end of the curve. Normally, heightening inflationary expectations, together with the fear of ballooning budget deficits, would be pulling long rates up more dramatically, but there’s some overhanging weight on the right side of the curve.
Bigger deficits wrought by the recent tax bill will ultimately need to be financed by increased Treasury issuance. That supply is likely to drive yields up on the long end—or it would ordinarily. There’s a case to be made for a great part of that issuance to end up in bond index mutual funds and ETFs. And that could keep the lid on long rates.
Should this guide investors to buy bonds or bond funds? Assuming investors accept the thesis, they have to be looking far downrange for their reward.
Technically, long-term bond funds look weak. The iShares 20+ Year Treasury Bond ETF (NYSE Arca: TLT), for example, has sunk more than 2.5 percent over the past two weeks and just saw its trading volume expand substantially as its price fell.
Is this a buying opportunity or a signal of continuing weakness over the intermediate term? The fund’s share price just broke below the $118 level, piercing near-term support. That’s a set-up for further declines. In fact, a price objective near $105 looms below. The last time TLT traded at that level was four years ago.
The next key support level is just below $117. Buyers may very well want to wait and see if that level holds before placing their orders.
Brad Zigler is WealthManagement’s Alternative Investments Editor. Previously, he was the head of Marketing, Research and Education for the Pacific Exchange’s (now NYSE Arca) option market and the iShares complex of exchange traded funds.
