One day it looks as though the U.S. could default on its debt and the price of the 10-year U.S. treasury rallies. The next day it looks as though the U.S. will raise its debt ceiling, the price of the 10-year note rallies. The U.S. could get downgraded by S&P, the 10-year note rallies. Moody’s affirms the U.S. AAA credit rating, the price of the 10-year U.S. treasury rallies. Concerns abound that the new budget legislation could put a modest drag on U.S. economic growth, the price of the 10-year note rallies. The slowing economy could cause the Fed to maintain or increase economic stimulus, the price of the 10-year note rises. One could be forgiven for believing that there is a bubble on the long end of the treasury curve. Whether or not that is true depends on how one defines a bubble.
Can the yield of the 10-year treasury note remain in the neighborhood of 2.60%? Over the long term, probably not, but it could remain range traded in the high 2.00% to low 3.00% area for an extended period of time. Note the words “extended period.” These are the same words the Fed has used to communicate how long it plans on keeping monetary policy exceptionally accommodative. When the FOMC meets next week, it is very likely that the Fed once again uses the phrase “extended period.”
The Fed is likely to remain exceptionally accommodative because recent data indicate that the economy is slowing. It was bad enough that consumer spending never ramped up as hoped, but now there are signs that the Global economy might be slowing. Although it is true that if countries like China slowed somewhat, their growth would still be robust, but put this into perspective: It has taken booming developing economies and the largest and longest-lasting infusion of economic stimulus since the Great Depression just to get us this far.
Possible future Fed actions are limited. QE3 is almost certainly out of the question, but the Fed could continue to reinvest maturing QE assets and hold off on asset sales and policy rate increases. This will keep short-term rates punitively low and push investors farther out on the yield curve. There have been suggestions that the Fed should eliminate the 0.25% rate it pays on deposits at the Fed to force banks to use that capital for lending. The counterargument is by doing so foreign banks (which have very large deposits at the Fed) and money market funds (which deposit a significant portion of their capital with the Fed) would be harmed.
I make the argument that as long as the curve is steep, banks would prefer to borrow on the short end of the curve and invest in 10-year notes to pick up almost 250 basis points. This so called carry trade may earn banks less than what they would earn by engaging in mortgage lending, but by purchasing the 10-year treasury note (effectively lending to Uncle Sam) banks do not have to be concerned about securitizing loans, dealing with delinquencies and foreclosures or running afoul of regulators by lending to those who cannot afford to pay or by carrying too much risk on their own books if the loans cannot be securitized. What incentives do banks have to lend to all but the most pristine borrowers? Not much from what we can see. Of course, what other borrowers than those who are very creditworthy and who are not over leveraged desire financing at this time?
Most other Americans are trying to climb out from under a mountain of debt accumulated during the most recent economic bubble. Several years were required accumulate such debt; many years are likely to be required to dispose of it. With unemployment expected to remain stubbornly high for years to come, the ability of consumers to repay their debts will probably be impaired. Consumer spending is also likely to be less than that to which we have become accustomed. As consumer spending makes up more than two-thirds of U.S. economic activity, economic growth could be below historical trends.
Readers know that I was never in the V-shaped recovery / spiking interest rate camp. I was of the opinion that the Fed would be very slow to tighten policy (I even correctly predicted how the Fed would remove accommodation). However, I also believed that long-term yields would rise gradually to the mid / high 3.00% area (further steepening the yield curve) as the economy grew at a below-trend pace (2.0% to 2.5%). However, recent and troubling economic data are pointing to “soft-patch 2011” or worse. This has sent the yield of the 10-year treasury note below 2.60%.
The bond market is pricing in a slowdown. Troubles in Europe and slower growth in emerging nations are causing the flight to safety. Even moves my central banks to increase gold holdings hasn’t stopped the rally on the long end of the curve. If economic data continues to disappoint (and I find it hard to believe that it will not), the Fed could remain on the sidelines throughout 2012 and the yield of the 10-year treasury note could become range traded between 2.50% and 3.00%. I would keep my exposure to LIBOR floaters very light. I will be back following Friday’s employment data.
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