Tuesday, August 3, 2010

10-30 spread hits record high

The spread between 10 and 30-yr Treasury bonds has hit an all-time record high of 114 bps, according to my quick review of history. This record curve steepening is not showing up in other areas of the curve, however, and the spread has widened sharply in the past week or so. This could be a signal that 10-yr bonds are benefiting from unusually strong demand, perhaps because the Fed has presumably leaked its intention to reinvest income and principal on its MBS holdings, rather than allow them to reduce its balance sheet. That's a tempting conclusion, but I think there are other things at work as well. 

The curve has been steep for some time now, and that is a classic sign of accommodative monetary policy and, and as such the curve presages a) an economic acceleration and/or b) rising inflation. Either one of those would be consistent with a widening of the 10-30 spread. 

It might also mean that those who were speculating on rising 10-yr yields have had to buy back their short positions, for fear that this presumed change in Fed policy will delay the rise in 10-yr yields. 

Whatever the case, a much steeper curve at the long end almost surely is a vote of no-confidence in the deflation scenario. If deflation were really a strong possibility, then investors would be buying the 30-yr and selling the 10-yr, betting on a flatter yield curve and locking in 4% yields on 30-yr Treasuries.

As I've said many times in the past, anything that diminishes the risk of deflation is automatically bullish from an equity investor's viewpoint. So the bottom line here is that the steepening of the long end of the yield curve is a positive, especially considering how bearish market sentiment appears to be, and how pervasive deflation fears appear to be.


John said...

I read a comment today where IBM borrowed money for 3 years at 1%. Not long ago Microsoft made a private placement of a $1billion 10 year convertible note at 0% with a $30 per share conversion price. During the CC mgmt indicated they bought in $3.8 billion in stock during the quarter.

Companies that can effectively earn high returns are doing very well borrowing at these ridiculously low rates. Shareholders are getting a great deal.

The downside to this as Public Library has astutely pointed out is the bad investment low rates can encourage. Yet, one can't help but think this gives the economy a kick in the pants.

John said...

Despite the steepness of the yield curve I still believe the government should do a trillion dollar 30 year bond sale.

Bill said...


Any concerns about the drop in factory orders? Also, the personal spending numbers weren't that hot either.

Benjamin Cole said...

The Fed is still fighting the last war, the one on inflation. Cultural norms, histories and self-recognized glory can become deeply entrenched, especially at public agenices (competition can wipe out non-nimble and self-glorying private companies).

As Milton Friedman said, low interest rates are a sign of tight money--people have little inflationary expectations--evidently zero in the case of Microsoft.

We may be headed for deflation. See Japan. Central bankers there, like central bankers everywhere, are preaching about stable prices and monetary rectitude and blah, blah, blah. A continual small dose of deflation gives central bankers something close to orgasm.

For the rest of the us, well, other more southerly body functions may come into mind.

UFormula said...
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UFormula said...

Or it could be the beginnings of sovereign problems in the US no? QE2? = Monetization of debt = Loss of confidence in the $ = higher inflation = Lower bond prices = higher yields.

Keeping an eye on commodities during the next correction/mini correction/consolidation is something i'll be doing.

Just speculating, but being a bear in just about everything the Fed and the administration is doing, the first thought was this.

John said...

At the risk of being accused of being a shill for Jim Cramer he has again said something I find myself in agreement with. He is calling the .5% yield on a two year treasury 'ridiculous'. He is right. .5% is NOTHING. Treasuries over time are toast. High yielding equities with great global businesses are cheap.

The US treasury should sell 30 yr bonds until the market chokes on them.

Mr. Kowalski said...

Scott you continue to be the most optimistic blogger I know. Today's numbers were awful, as were the vast majority of last week's. If all is well and the recovery is soaring, why is the 10yr hovering around 2.9% ? My thought is that this might be a European thing; the Euribor is skyrocketing, though it has cooled off this week. Europe's banking system is in real trouble, and Europeans should all enjoy this little summer holiday from reality.

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Scott Grannis said...

Mr. K: I think you've answered your own question. The 10-yr is 2.9% because everyone is bearish on the economy's prospects and also very worried about deflation. That's the only explanation that makes sense: there is a real shortage of optimists right now.

Scott Grannis said...

Bill: I've never paid much attention to factory orders. But to counter them look at the ISM indices which are all pretty strong. I think I trust the ISM indices more than I do the government's attempt to count factory orders.

As for personal income and spending and even savings, those are good indicators for a Keynesian-based approach to the economy. But for a supply-sider they don't mean much. It's not demand that drives the economy higher, it's supply (investment). That's still sluggish, but there are lots of profits out there waiting to be invested, and capital goods orders have been doing pretty well of late.

Frozen in the North said...

QE II would be a disaster for the country (and investors) since the only place left to ease will be at the long end of the curve. Worse case scenario is that the 30 year start yield compress further.

There is no room in the medium or short term end of the spectrum since rates are already so tight.

America is embarking with two feet on a Japanese boat -- it didn't end well for Japan, it is unlikely to end well for America.

The implication of lower long term rates will be to increase savings -- since people target an absolute return

John said...


While I don't think it would be a disaster I don't think the fed does anything. QE is largely an emergency measure and while many think we are in a deflation (something the data does not confirm) and more QE is justified, I don't think the majority of Fed Open Market Committee members are thinking that way. Also, we are nearing an election and in my experience the Fed does not like to get active around elections fearing criticism from politicians. If there were an unquestioned emergency it would not be a factor but optional moves that can be put off for a few weeks are unlikely to be made.

Just my cheap opinion.

Public Library said...

Frozen has a point. Lower rates beget even more savings just to keep up with the deterioration in the return on your money. It's a self-fulfilling cycle.

Additionally, why invest in higher risk projects and employ more people when you can simply borrow for nothing and earn the spread risk free. That is, if you are a large corp of course.

The Fed is indeed embarking on Japan II. They have it all backwards.

Raising rates forces the animal spirit to truly seek out higher absolute and of better quality returns per unit of risk.

Instead, the Fed is heading the other direction dumping moral hazard all across the landscape with low rates but not necessarily cheap money for all.

I am 100% confident Bernanke will get the next storm incorrect. It is already baked into his DNA.

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