| Barron's
Current Yield: Yield Curve Offers Surprises, Even If Fed Doesn't
(From BARRON'S)
Finally.
The slope of the yield curve, which represents
the sum of the market's expectations of future short-term rates, flattened in
spectacular fashion last week, following the Federal Reserve's unsurprising decision
to raise short-term interest rates for a third time.
To those who watch
the curve religiously, the flattening that occurred in the middle of the week
was beyond stunning.
"The extent to which we are seeing a bullish
flattening really is unprecedented, as this usually occurs during the late stages
of a tightening cycle or implies the rate cycle is approaching its peak,"
said Marc Seidner, director of domestic taxable fixed-income at Standish Mellon
Asset Management, on Thursday.
A bull flattener occurs as a result of long-term
bond yields falling, rather than short rates rising. In this situation, financial
markets are sensing an economic slowdown and have little fear of inflationary
pressures over coming years.
"The pace of economic activity is slowing,
perhaps dramatically, and the terminal rate for fed-funds could be 2% to 2.5%
-- but the bond market is treating that as a certainty!" said Seidner.
"I think we still need more evidence," he added.
The Federal
Open Market Committee increased its federal-funds rate target by a
quarter-point,
to 1 3/4% on Tuesday. The accompanying statement also met
expectations, restating
Chairman Alan Green- span's recent congressional testimony describing output growth
as having "regained some traction," and labor-market conditions as having
"improved modestly."
The statement also said that "despite
the rise in energy prices, inflation and
inflation expectations have eased
in recent months."
Peter E. Kretzmer, senior economist at Banc of America
Securities, wrote to
clients that "without committing itself to one particular
course between now and
year end, the Fed certainly signaled that it doesn't
consider itself finished
with the job of removing policy accommodation."
In that regard, "I think the two-year note is death," said Seidner.
"At only
75 basis points over the current fed-funds rate in a tightening
cycle, there
isn't much room for the two-year note to keep pace in a further
rally." (A basis point is one-hundredth of a percentage point.)
"Conversely,
in a sell-off," added Seidner, "it would be likely that the two-year
note would lead a move higher as Fed expectations get repriced."
And
the price on the two-year note, the coupon issue most sensitive to moves by the
Fed, did indeed sell off sharply Friday, extending the flattening in the curve
-- but this time, with short rates rising and narrowing the gap with long-term
bond yields. On Friday, the yield on the two-year note traded as high as 2.60%,
up from Thursday's close of 2.52%, as investors and bond traders adjusted their
views on the back of Thursday's release of Aug. 10 FOMC minutes.
The minutes
showed that policy makers believed softness in U.S. economic data
would be
"short-lived" and "significant cumulative policy tightening likely
would be needed."
"This is the way the curve should flatten,"
with short-term rates rising faster than longer-dated yields, says Seidner about
the so-called bearish flattening.
By week's end, the yield on the benchmark
10-year note settled at 4.03%, but
not before breaking through 4% on Wednesday
to 3.98%, the lowest level since
April. The rally contributed to a spread
narrowing between the 10-year note and
that of the two-year of 145 basis points.
Equally remarkable last week was the rally on the long end of the curve.
The
yield on the 30-year Treasury bond declined more than 10 basis points
on the
week, to 4.80%, down from 4.91% the previous week.
No one enjoyed
it more than Van Hoisington, president of Hoisington Investment
Management
in Austin, Texas, a firm invested only in long-dated Treasuries. "The
long end has been extraordinarily cheap relative to the short end," especially
with inflation and inflationary expectations easing and global growth weakening,
he says.
In sum, the yield curve flattened nonetheless.
"People
see this measured rise in interest rates and kind of figure that inflation is
under control, volatility is low, so reach for yield while you can
get it,"
says Andrew Harding, director of taxable fixed-income securities at
National
City Investment Management.
The rally in Treasuries reverberated through
other parts of the credit markets, notably in the mortgage sector, where the sharp
drop in rates raised the prospect of a new wave of home-loan refinancings. That,
in turn, exacerbated the price moves in the Treasury market.
Bond managers
that hold mortgage securities face greater-than-expected
prepayments when
yields fall, so they buy noncallable Treasuries to hedge that
risk.
And
just as homeowners have taken advantage of falling rates, corporations have wasted
no time tapping the debt markets in droves. Companies, especially financial firms
including Goldman Sachs, JPMorgan Chase, National City Bank and Wells Fargo, last
week issued 22 investment-grade bond deals totaling $16.5 billion, according to
Thomson Financial. Still, at $486 billion, new issuance is modestly behind last
year's figure of $492 billion.
Aside from digesting the huge corporate-debt
offerings last week, money managers were also digesting a damaging report by the
Office of Federal Housing Enterprise Oversight about Fannie Mae's accounting practices
-- or lack thereof.
Subsequently, rating agency Standard & Poor's placed
Fannie Mae subordinated
debt, preferred stock, and its stand-alone rating
on CreditWatch negative.
On the week, the spread on 10-year Fannie Mae bonds
increased about six basis
points, and on Freddie Mac the spread rose about
2.5-to-three basis points.
"Six-to-seven basis points of widening isn't
a life-threatening situation," says Harding of National City about Fannie
securities. "In the long run, I still believe this is an equity issue, not
a debt issue."
Harding says "the most important issue" regarding
Fannie Mae is the election:
"If Bush wins re-election, regulation is
on the way, and this last report just gives the Bush administration more ammunition
to regulate the government-sponsored enterprises. It makes the bonds eventually
stronger." He continues to hold his position in agencies.
From Fannie
to the Fed to oil prices, which settled at a record $48.88 closing
level Friday,
Treasuries, especially longer-dated maturities, benefited.
"The landscape
is going to stay very difficult," says Peter McTeague, interest-rate strategist
at RBS Greenwich Capital. "Rates could very well stay here, plus or minus
30-to-50 basis points, and that hurts people. It isn't what people want to see."
But he quickly adds that investors have to consider the fundamental story
"that got us here" -- that is, a moderation in global growth and an
easing in inflation and inflation expectations.
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