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Yield Curve Invert

Yield Curve Inversion

Why in the world would anyone buy a 10-year Treasury yielding 1.52% when they could buy a 3-month Treasury yielding 1.89%? There is no single answer. Speculators like the 10-year because it is more volatile than the shorter-maturity bonds. On August 1, the 10-year was yielding 1.90% - that is a 20% change! During the same two-week period, the 3-month Treasury yield moved just 8.7%. But the market for U.S. Treasuries is not just speculators.

U.K. bonds are yielding 0.41%, not only a lot less than the U.S. 1.52%, but the U.K. has Brexit hanging over their heads. Nobody wants to deal with that uncertainty. The German 10-year bond is currently yielding -0.72%. Imagine paying a bank $7.20 to keep $1,000 in a savings account for 10 years! Clearly, if I am in another part of the world and I am in a situation where I need to stash large sums of currency - perhaps I am an insurance company, large corporation, or even a sovereign wealth fund - then I am surely looking towards U.S. bonds.

Thus, we have speculators and large offshore institutions all buying in the 10-year Treasury market, which drives the price of bonds higher and conversely, drives the yield lower. That is not the only affect, though. To buy U.S. bonds you need U.S. currency. The dollar index began the month at 98.37 and that is where it sits, today – 98.24, despite the Fed rate-cut, which would normally have a dampening effect on the dollar. All things being equal, many would welcome a weaker dollar, which would tend to make our goods and services more attractive, internationally. Higher U.S. interest rates, compared to the rest of the major developed countries, has been a (slight) drag on S&P 500 earnings.

The only remedy to this situation, where U.S. interest rates are markedly higher than that of its peers, is for the Fed to continue lowering its target rate (currently 2.00 – 2.25) in order to bring its overall yield curve back into order (higher yields on the long-end). Will this have unseen ramifications to the U.S. economy? Without question.

-- Scrib