Lambert here: Richter argues that if the Fed unwound its balance sheet, that could drive up long-term yields, and unflatten the yield curve. But that moment of truth seems not to have yet arrived, if indeed it ever does arrive, or needs to arrive.
By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Originally published at Wolf Street.
Prices of US government bonds fell across the board on Friday, and their yields rose and set a number of nine-year highs, in some cases nine years to the day.
Many people have pointed at the Senate where the prospects of the tax cut are said to have “brightened” when the Senate approved a budget resolution. The tax cuts, if they make it, are said to lower government revenues by $1.5 trillion over 10 years. So maybe the bond market is starting to pay attention to government deficits and the national debt once again. But the bond market hasn’t paid attention in many, many years, and until the proof is in, I doubt it.
There are, however, other factors that predate Friday by many months. In fact, the moves in Treasury yields for maturities up to two years have been fairly consistent: yields have been surging.
On Friday, the three-month Treasury yield rose to 1.11%, the highest since the brief spike around July 25, when the debt ceiling issue hit a speed bump. At the time the thinking was that in late September – when these securities would mature and the government would have to come up with the money to redeem them – the government might not be able to come up with enough money due to the debt ceiling. But this scare passed, the debt ceiling was extended temporarily, and the trajectory of the three-month yield returned to normal. Except for this spike, the three-month yield, at 1.11%, is now at the highest level since October 20, 2008 (let’s remember that date, it keeps cropping up):
In 2013 through 2015, the 3-month yield bounced around at near zero, and actually hit 0% several times in October 2015, which was the low point. In December 2015, the Fed raised its target range for the federal funds rate for the first time since July 2006. By now, it has raised the target range three more times, and it will likely raise it again in December.
The one-year US Treasury yield rose to 1.43% on Friday, the highest since October 29, 2008. It never quite got to zero but fell as low as 0.1% in 2011 and 2014:
The two-year yield surged to 1.60% on Friday, the highest since October 20, 2008 – that date again. That was nine years ago to the day:
The two year yield is particularly significant in relationship to the 10-year yield: The difference between these two yields — the “spread” — has made its way onto the Fed announced worry list.
As the two year yield has surged since 2014, the 10-year yield has spent a lot of energy jumping up and then meandering lower, hitting 1.37% in August 2016, the lowest in the data series going back to the 1960s. The yield then spiked with the election, nearly doubling in a few months, reaching 2.62% in March this year, before swooning once again. But it has been rising recently and jumped 6 basis points on Friday to 2.39%:
This is where the Fed begins to worry: The spread between the two-year and the 10-year yields dropped to 0.75 percentage points on Thursday, the lowest since November 2007. At the time, the spread was widening after having been negative in late 2006 and early 2007 – due to the “inverted” yield curve – as the Financial Crisis was beginning to crack the banks.
On Friday, the spread widened to 0.79 percentage points, as the 10-year yield had risen more sharply than the two-year yield:
The negative spread between the two-year and the ten-year yield into the Financial Crisis still resides in the Fed’s collective memory banks. And they have put the collapsing spread onto their public worry list and have mentioned it in recent weeks. The Fed is concerned about the low long-term yields in the face of rising short-term yields. Generally, nothing good comes of this combination.
The fact that the ten-year yield isn’t moving properly in the same direction as the one-year and two-year yields should be one more reason for the Fed to pursue its QE unwind relentlessly. Unwinding its balance sheet that is loaded up with long-term securities would help drive up long-term yields. It would steepen the yield curve. And it would thereby pull the yield spread off the worry list. But for now, the numbers for that QE unwind are not lining up.
Curious things are happening on its balance sheet. Read… Is the Fed Getting Cold Feet about the QE Unwind?