Monday, April 28, 2014

Unintended Consequences

Two weeks ago we wrote about a bear flattening and discussed the especially vulnerable short end of the curve. Since that writing, 5 year Treasuries have moved from 1.58% up to 1.74%. The 30 year has gone from 3.48% to 3.49%. The curve is flattening and it is flattening from the most manipulated end: The short end.

So what is causing the slow rise in interest rates when everyone expects a slightly faster rise? And if the banks have lots of cash available, why do there continue to be complaints about access to borrowing? Any time there is government intervention in the markets, there is most likely to be unintended consequences. One unintended consequence of the increased liquidity standards forced upon banks is the lack of liquidity for borrowers.

Banks have been forced to strengthen their balance sheets as a result of the 2008 financial crisis. A liquidity coverage ratio has been established for the banks and only cash and Treasuries and Agencies count fully in that ratio calculation. The result? Banks need to keep more assets on hand to cover times of  "stress" and the best instruments that banks can use happen to be Treasuries and Agencies. So, once again, we have an unnatural demand for Treasuries on the short end of the curve, which is why on days like today we had 10 Year Treasuries briefly at 2.67%. Also, since banks need to keep more cash on hand to prevent a similar fiasco to 2008, banks cannot lend in the way that they used to. As a result, there are now businesses and individuals that historically looked like good candidates for lending, but now cannot be lent to due to the banks' need to beef up their own balance sheets.

If the economy keeps growing, and when banks reach the ratios that are acceptable, we expect that the short end of the yield curve could move up in yield faster than we've seen recently. Again, the short end most likely has the most risk and needs to be approached very cautiously.





Sunday, April 13, 2014

Rising Interest Rates and a Flattening Yield Curve

What exactly tends to happen when the Fed tightens (raises interest rates)?

Historically, the yield curve flattens, meaning the difference between short term interest rates and longer term interest rates becomes less, when the Fed tightens. For example, currently, the 5 year Treasury to 30 year Treasure curve is 190 basis points (the 5 year is 1.58% and the 30 year is 3.48%). A flattening means that difference may go from 190 basis point to 150 basis points. But which bond will change? If the 30 year went to 3.08%, and 5s stayed at 1.58%, we'd have our 150 basis point steepness as a result of a bullish flattening. If, instead, 5s went from 1.58% to 1.98%, we'd also have a 150 basis point difference, but it would be the result of a bear flattening.

According to some recent research by BMO Harris, the market appears to be heading for a convergence point in interest rates below 3.75%. In other words, the long bond may fade 20 to 25 basis points, but most of the flattening will come from bear flattening on the short end.

Where exactly will the bond market rise in yield the most? Current studies show the very short part of the curve (Bills to 5 years) is most likely the most vulnerable. As of right now, we have:

1 year: 0.09%
2 year: 0.36%
5 year: 1.58%
10 year: 2.62%
30 year: 3.48%

Perhaps, once the US Government exits the bond manipulation game, we'll see Bills at 2.25%, 5s at 2.85%, 10s at 3.40% and the 30 year at 3.65%. This would be significantly flatter, with bear flattening all through the curve, but with the majority of damage on the short end. For many, this is the most intuitive shape of the interest rate rise simply because the Fed is manipulating the short of the curve the most extensively.

Keep an eye on curve shape, and don't assume that holding 5 year bonds absolves you of all risk. Again, the short end of the curve is being unnaturally manipulated and probably is the most vulnerable to change when the Fed exits.