Ever since the Federal Reserve finished tapering off of its quantitative easing (QE) program in October of last year, the market for U.S. Treasurys has seen a prolonged bout of uneven trading. Benchmark bond yields have fluctuated fairly wildly, sinking as low as about 1.80% while in the throes of the strongest safe haven demand, and rising as high as the 2.40% range when government debt seemed like a less attractive bet.
There are some interesting conclusions to be drawn from reading between the lines of the market for U.S. Treasury bonds. In short, 1) everyone’s lost faith in central banks; 2) nobody expects inflation to pick up any time soon; and 3) the issuance of new short-term debt has hit a snag.
Lack of Credibility
Many have called the tendency for central banks to make bold policy pronouncements as a means of manipulating market sentiment and trader expectations the “Crying Wolf” effect. After several years of seeing the tactic play out month after month, people are naturally losing their patience and trust in the judgment (or honesty) of central bankers.
For instance, Federal Reserve Chair Janet Yellen has been rather insistent that the FOMC will move on increasing the federal funds rate at some point in the near future. She has reiterated that she expects the rate hike to come sometime in 2015, but with just two FOMC meetings before the end of the calendar year, this possibility has become increasingly smaller.
How do government bonds tell us anything about this? Simply enough, the surge in demand for short-term Treasurys following the Fed’s announcement in September that there would be no rate hike for at least another month shows that these traders, investors, and large institutions no longer believe that rates will go up this year. Why would you buy a 3-month bond at its current yield if you believed (even tacitly) that interest rates would be higher before the bond matures? The answer is that you almost certainly wouldn’t; you would wait until rates go up to take advantage of the better yield.
Where’s the Inflation?
The same game of getting people to “buy the rumor, sell the news” has been sold by the Fed regarding inflation. The central bank, like most central banks, maintains the somewhat arbitrary target of 2% for a healthy inflation rate. For much of the past two years, the pace of price inflation in the U.S. has run well below this level—in fact, it has hardly moved off of zero in 2015, never registering above 0.2%. Inflation has even dipped into the negative (i.e. deflation) for the first time since the wake of the financial crisis in 2009.
Despite this reality, Yellen and her cohorts at the Fed have consistently stressed that they believe inflation will pick up in the very near future. There aren’t even any signs that this is remotely the case.
Therefore, the principle of using bonds as a gauge again comes into play: yields are simply going to be lower on Treasurys when inflation expectations aren’t high, because the government is fairly intent on only covering the rate of inflation in its bond yields. 3-month Treasurys hit their lowest-ever yield of 0% (and, briefly, even slightly negative) this week.
New Bonds Halt at Debt Ceiling
On top of it all, there is problem of the debt ceiling. Until Congress resolves its spending bill battle that threatens to shutdown the government, the Treasury Department won’t know how much extra room it will have to work with in the issuance of government debt. By most current audits, the Treasury is approaching the current limit (or “debt ceiling”) to how much money it can borrow, meaning that new short-term Treasurys can’t be issued until perhaps next year.
Here, the Treasury market is providing us with indications about the government’s relative solvency and the limitations to keeping the markets running as normal with the federal government temporarily out of the picture. This may very well be the shortage of near-term bonds that “Bond King” Bill Gross warned off last year.
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.