The Humpback Treasury Curve What does it mean for investors? Focal Point 2/10/00 By Evelina M. Tainer, Chief Economist

What a difference a day (or two) makes
In early January, economic data showed that 1999 had ended on a robust note and market players realized that the Fed would have to raise rates early at their first FOMC meeting of the year on February 1 & 2. Inflation news was mostly benign although survey data showed that raw materials prices were accelerating. Oil prices remained high as well. As a result, expectations of rate hikes by the Fed led to a rising rate environment in the Treasury securities market in early January. The Treasury yield curve was positively sloped through the first half of the month; that is, yields on long-term securities were higher than yields on short-term instruments.

By the third week of January, the yield on the 30-year bond dipped six basis points below the 10-year note. Historically, it isn't unusual to see the yield on the 30-year bond to run 25 basis points over the yield on the 10-year note. In December 1999, the spread had narrowed to 10 basis points. By the first week of February, the spread went to a negative 30 basis points! By February 7, the only Treasury security that didn't have a negative spread to the 30-year bond was the 3-month bill!

Benchmark status in question
Treasury securities are benchmark instruments in the fixed income market and in high demand because of their risk-free default status. In particular, the 30-year Treasury bond was the only such long-term security in the world. All other major industrial countries only offer 10-year bonds at the long end of the curve. The U.S. 30-year is still formally at least the key benchmark, many fixed income instruments are pegged to it and bond traders typically offer spread relationships over it in making quotes. The 30-year bond also served as a measure of inflationary expectations. Bond yields went up when inflation expectations rose, and went down when expectations fell. While it is too soon to know where the bond market will go from here, it is useful to understand what happened in the early days of February that may end up permanently changing the structure of the U.S. Treasury market.

Budget surpluses galore
Fiscal year 1998 saw the first budget surplus in 30 years. It wasn't a fluke - another budget surplus was recorded for fiscal year 1999. The stage is set for a budget surplus in the current fiscal year (2000) as well. Yes, the Administration and Congress made some changes in federal outlays, but a good portion of the surplus can be ascribed to surging tax receipts coming from a booming economy in the second half of the 1990s. A low inflation environment helped to keep down interest rates. This dampened the growth in net interest payments on the national debt in recent years.

Outlays and receipts of the federal government are not inconsequential to bond market investors. Indeed, the U.S. Treasury determines the borrowing needs of the federal government and then issues Treasury securities to finance those needs. Some economists (including ourselves) have noted in the past couple of years that budget surpluses would eventually lead to a reduction in the supply of Treasury securities. The Treasury eliminated the 3-year note auction in mid-1998. At the same time, it reduced the number of 5-year note auctions from 12 per year to four per year. The Treasury had already reduced the annual number of 30-year bond auctions in the previous two years from three to two.

In the fourth quarter of 1999, the Treasury announced a program to buy back off-the-run long bonds. Off-the-run bonds are those that are no longer the current issue. For instance, as time passes a 30-year bond will have 28 then 27 then 26 years to maturity. New issues of 30-year bonds are generally preferred because they are more liquid (easy-to-trade) than the odd-year maturities.

Were bond traders on break for the past few months?
The Treasury announced its quarterly refunding package (auction of 5-year notes, 10-year notes and 30-year bonds) on February 2. (Ironically, this scheduled event was the same day as the FOMC meeting and was held the morning before the Fed raised its federal funds rate target by 25 basis points.) Together with the refunding, the Treasury announced that it was scaling back the issuance of 30-year bonds by half. At the same time, it announced that the 52-week bill would be auctioned quarterly rather than every four weeks. Furthermore, the buyback program was reiterated but noted to be slightly more aggressive than the initial report.

On its own, the Treasury announcement would not have caused such a ruckus in the bond market. Ken deRegt, chairman of the Treasury Borrowing Committee of the Bond Market Association (and managing director at Morgan Stanley Dean Witter & Company) gave a noteworthy interview to Market News International. DeRegt claimed to be baffled by the market behavior. He felt that the turning point occurred a few days earlier when the Congressional Budget Office (CBO) issued its revamped economic assumptions and estimates of the budget over the next decade. These estimates are independent of White House prognostications and therefore carry more weight in the bond market. According to the CBO, there was a real chance that the non-Social Security surplus could total as much as $1.9 trillion, but at least $839 billion. DeRegt believed that these figures resonated with bond traders.

Efficient markets theory doesn't hold water here
The Treasury announcement of a reduction in Treasury securities coupled with the CBO estimates of budget surplus made supply problems more real in traders' minds. Given that the Treasury openly declared its intentions over the past year, and the government budget surpluses are not new, the theory that markets are efficient would suggest that all this information should have been incorporated into Treasury bond prices over these past several months. Yet, the inverted yield curve negates the absorption of the information by bond investors. Instead, it indicates that this information wasn't digested by traders at all. So much for full information and efficient markets …

30-year Treasury loses benchmark status
In the United States, bond investors and policymakers have looked to the 30-year bond to glean market expectations of inflation. Whether inflation is actually accelerating, or bond investors just expect inflation will worsen, it becomes immediately evident in the 30-year bond yield. When inflation abated in the 1980s and 1990s, the yield on the 30-year bond came tumbling down.

In times of financial turmoil, investors from home and abroad have turned to the 30-year Treasury bond. During the Russian financial crises and the subsequent near-collapse of the Long Term Capital Management hedge fund, the safe-haven status of the U.S. Treasury market led to yields near 5 percent on the 30-year bond.

The reduction in the supply of 30-year Treasury bonds is a structural change in the market. When some segment of the market is undergoing structural change, the indicator used to monitor that market becomes less useful.

Many economists are already pointing to the 10-year note as the next benchmark security. Indeed, mortgage rates for 30-year loans have already been tied to the 10-year note market. As bond investors and speculators turn to a new benchmark, it is likely that greater market volatility will ensue. It may take more than a few weeks or a few months for a new benchmark to become fully established, firmly entrenched in market sentiment.

Treasury turmoil create disastrous auctions
Notice the sharp volatility in Treasury yields of the 10-year note and the 30-year bond over the past two weeks in the charts above! The plunge in the yields on February 2 & 3 was due to the Treasury announcement of the reduction of the 30-year bond. The two-day run-up in rates on February 9 and 10 came from remarks made by Treasury Secretary Larry Summers. He claimed that the Treasury would reduce borrowing through the entire yield curve. Bond traders took this to mean that the 30-year bond would not be reduced after all. This confusion in the market place led to terrible auction results for the 10-year note on February 9 and the 30-year auction on February 10. The demand for both issues plunged relative to historical experience. It is probable that the demand for these two issues would have been greater if Summers hadn't commented further on Treasury plans.

Agencies, mortgage-backed securities, corporate bonds…
When the Treasury first announced its plans to reduce the supply of 30-year bonds last year, two federal agencies quickly stepped up to bat. Both Fannie Mae and Freddie Mac began issuing long term securities more aggressively. While the government does not issue these agency securities per se, they are viewed as "virtually risk free" because the federal government guarantees them. Neither has defaulted on their debt before. Some analysts question whether agency securities will develop into true benchmarks as they often move together with mortgage-backed securities - and that is one of the major instruments that bond speculators try to hedge against.

Investment grade corporate bonds might develop into benchmark securities. Ford and GE have stepped up its issuance of long term debt as well these past several months. While they may have a good history, these can't be labeled default-risk free, though.

THE BOTTOM LINE
Investors have long flocked to Treasury securities for risk free investment opportunities. Some individual investors may have shifted away from bonds in recent years to take advantage of the more lucrative returns in the equity market. Yet, financial planners continue to recommend a well-balanced portfolio, which includes some bonds, for individual investors.

Investment grade bonds (rated triple A by Moody's or S&P) as well as Fannie Mae and Freddie Mac bonds may be good investment options for individuals interested in long term bonds with low risk of default. And for those who want some intermediate term securities, 2-year, 5-year and 10-year Treasury notes are probably here to stay even if President Clinton estimates that the government debt will be eradicated completely in the next 15 years.

As to monitoring inflationary expectations in the interest rate market, those individual investors who have closely followed changes in the 30-year bond will have to shift focus a bit.

Last updated February 10, 2000