Earlier this week, the two-year and five-year U.S. treasury auctions drew weak interest from investors concerned that the Fed may need to unwind its stimuli and raise short-term borrowing rates to combat inflation. With the results of shot-term auctions fresh in their minds, market participants eagerly awaited the results of today's seven-year treasury note auction. However, unlike the two-year and five-year note auctions, the seven-year not auction was quite well received. Why was this so?
To understand why investors, such as foreign central banks, were more willing to buy longer-dated treasuries one must first understand the yield curve. The yield curve must first be divided into the long and the short end. Short-term yields are directly influenced by Fed interest rate policy. Two-year and five year auctions were thus weak. However, recent ten-year and thirty-year auctions garnered much interest (along with today's seven-year auction). This is because long-term yields are reflection of inflation expectations and the market is not expecting much.
How can that be you say? The U.S. government is issue debt and printing dollars in record amounts, how can inflation be moderate? Weak job growth and subdued economic activity will keep inflation from spiraling out of control. The lack of decoupling between the U.S. and its trading partners will also help to keep prices down as exporting countries work to keep currency exchange rates favorable. The Fed will also work to keep inflation moderate by removing stimulus and raising rates. Still, inflation will creep higher and long-term rates will rise accordingly.
If inflation and long-term rates will rise, why do not foreign investors simply purchase short-term treasuries and reinvest at ever-higher yields? Because the are not retail investors (sorry for the shot, but the truth hurts). Foreign buyers of U.S. treasuries know that when the Fed becomes less accommodative it moves at a glacial pace, typically 50 basis points at a time. This means that, even if the Fed raised the Fed funds rate at all eight FOMC meetings in a given year, the Fed Funds rate would only rise by 400 basis points. Even that gradual scenario is probably too aggressive considering the head winds facing the economy from deleveraging, higher taxes and other anti-growth policies brewing on capital hill.
This leaves one with a dilemma on the short end of the curve. Buy the two-year or the five-year and one could go through an entire rate cycle without being able to roll at a higher yield. But T-bills and one spends so much time at ultra-low yields similar to what we have today and it is difficult to equal the yield once could lock in by purchasing the 10-year treasury note.
Retail investors often make the mistake of assuming that when short-term yields rise, long-term yields must respond in kind. First, short-term yields almost always rise faster than long-term yields during times of Fed tightening. This is because short-term yields respond directly to higher Fed Funds rates, but longer-term yields are influenced by inflation expectations, which usually abate as tighter Fed policy crimps growth. Secondly, long-term rates may not rise at all when the Fed tightens as a combination of modest inflation expectations and foreign currency management results in large scale long-term treasury buying (as seen with Greenspan's so-called conundrum).
The bottom line is the market is forecasting a flatter yield curve and although it may be 18 to 24 months away, it is coming.
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