In the trouble-tossed world of finance,the one safe place during the credit crisis has been America’s vast and liquid Treasury-bond market. No longer. Since touching a record low of 2.04 per cent in mid-December,ten-year bond yields shot up above 2.9 per cent on February 4th,continuing a sell-off that made January the worst month for government securities in decades.
There are several reasons for the reversal of fortunes,not all of them bad. Yields tumbled last year partly because panicked investors jettisoned every other sort of fixed-income security,such as asset-backed bonds,corporate bonds,even the Treasury’s inflation-protected bonds,known as TIPS. Some tentative signs of healing in the credit markets suggest the panic has ebbed,and spreads between Treasury yields and more risky bonds have narrowed.
Another big factor appeared to be the threat of deflation that loomed over America’s economy as consumer prices slipped. Any sign this is weighing less on investors’ minds would be welcome. When bond yields hit their lowest,the spread between yields on nominal Treasuries and TIPS implied that the market was factoring in deflation of 5.5 per cent in 2009 and zero average inflation for the next decade,according to Michael Pond of Barclays Capital.
But the fear of deflation may not have been the overriding concern,Mr Pond argues. More important,he says,investors deserted relatively illiquid TIPS in favour of nominal bonds,driving the yields in opposite directions. The same spread now implies,implausibly,deflation of 2.5 per cent this year,and zero inflation until 2014,before reaching 2-3.5 per cent thereafter. In that case,nominal yields could rise quite a bit more relative to TIPS yields without signalling an inflation scare.
As in all markets,supply and demand have played a big role. Yields were driven down in December after the Federal Reserve declared that it was considering purchases of long-term Treasury and mortgage debt in order to lower long-term interest rates (it later reduced short-term rates virtually to zero). It went ahead with the purchases of mortgage debt. But at its last meeting on January 27th,it merely retained the option to buy Treasury bonds. That disappointed investors.
The biggest force behind the bond-market shock is the onslaught of new issuance as the government seeks to finance the gaping budget deficit,Fed liquidity programmes,mortgage purchases and bank bail-outs. Yields moved still higher this week partly on the Treasury’s announcement that it would borrow a whopping $493 billion this quarter. Wrightson ICAP,a research firm,predicts the Treasury will issue $1.8 trillion this year,which combined with $1.5 trillion last year,would exceed all the net borrowing of the prior 27 years combined (see chart).
Meanwhile,the Treasury is facing growing competition for funds in the corporate-bond market,which has seen some unusual levels of activity since the start of the year. Excluding debt backed by the government,the total reached $76 billion,not far short of the previous record for a January,$82 billion in 2001.
The revival of corporate-bond markets,if sustained,would be good news. Moreover,there is still sturdy demand for Treasuries from abroad; foreigners refused to dump them even when they lost confidence in mortgage-backed debt last year. But America cannot take things for granted. If private credit continues to revive and there is no sign budget deficits are coming down,investors may worry that America will attempt to inflate its debts away. Then the storm really will hit Treasuries.
© The Economist Newspaper Limited 2009