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Deus Ex Machina
By Arun Motianey
The Fed and the U.S. Treasury Yield Curve
The Fed announced after its August 10 Open Market Committee meeting that it will reinvest principal payments from agency debt and MBS in Treasury securities. The consensus is that this would amount to about US$300 billion of purchases over the next year and this figure sounds reasonable. The Open Market Trading Desk said it will concentrate purchases in the 2-10y sectors of the nominal Treasury curve, but given the already low level of front-end yields it is more likely that purchases will be directed toward the intermediate sector (5-7 years, but extending to 10 years). Sure enough, the markets reacted immediately in line in line with these expectations: The Treasury curve steepened in the long end: while 2y, 5y, and 10y yields fell 0.8bp, 4.5bp, and 4.4bp respectively; 30y yields increased by 2.3bp. This morning the 10y Treasury yield breached our expected level of 2.70%.
While there is a risk of a partial reversal of the rate rally driven by breakevens, we do not expect a large move in rates in either direction this time. Note that the 10y yield declined by 50bp on a US$1.25 trillion expansion in the size of the asset purchase program on March 18, 2009, but gave back half of it by the end of the month as 10y TIPS breakevens widened. The decline in 10y yields that began in Q2 has been accompanied by a period of falling real yields, then a short period of falling breakevens and now, most recently, falling real yields again (Figure 1). This time around investors will be expecting further asset purchases; hence we do not see a selloff on anything like the scale from Q1 2009.
Figure 1: Decomposing U.S. Treasury 10-Year Yields
The decline in 10y yields that began in Q2 has been accompanied by a period of falling real yields, then a short period of falling breakevens and now, most recently, falling real yields again.
For now our 10-Year U.S. Treasury yield forecast still stands at 2.70% informed as it is by our Q3 macro view on the U.S. economy, though flight-from-risk could drive it lower temporarily. If, however, the Fed should announce an enhanced Treasury or mortgage purchase program we would be likely to amend this point forecast downward.
What does this do to yield curve dynamics? The announcement of the central bank’s intention not to shrink its balance sheet (“proto-QE”) did not interrupt the flattening in the 2s5s sector or the steepening in the 10s30s sector of the U.S. Treasury curve (Figure 2).
Figure 2: U.S. Treasury Intra-Curve Spreads
The 5s10s spread saw no change. However, we expect this trend to slow but only by a little and the belly of the curve (5y), clearly the richest part, will still rally against the longs (10y) or the ultra-longs (30y). The steepest part of the curve, the 10s30s in both the U.S. Treasury and UK gilts market, have moved with the 1y1y forward swaps in an inverted relationship but have outpaced them recently and we should expect the two to return to a closer relationship (Figures 3a and 3b). The steepening of the U.S. 5s10s and the flattening of the U.S. 10s30s is one of the reasons for our not adjusting our U.S. 10y yield further down.
Figures 3a and 3b: Treasury Curve Spread and Forward Swaps; Gilt Curve Spread and Forward Swaps
There are interesting cross-market implications as well. The short-dated forward swaps market is shaped by Eurocurrency futures contracts. The Eurodollar-Euribor spreads on all but the nearest contracts, i.e., the red packs (the average of the 5th-8th contracts), the green packs (the average of the 9th-12th contracts) and the blue packs (the average of the 13th-16th contracts) have all dropped precipitously implying that the U.S. central bank will maintain much more accommodative policies than its eurozone counterpart. This is not consonant with our relative outlook on the two economies and we would expect the spread on all three packs to reverse before end-2010 (Figure 4).
Figure 4: Eurodollar/Euribor Futures Spread