Yield Curve "Conundrum": Blame Japan for Flat Treasury Curve?

Citigroup blames Japanese banks for the flat yield curve. The BIS notes a conundrum. Neither explanation is correct.

A Citigroup analyst says don't worry about the flat yield curve. Instead, Blame Japanese Banks.

“We believe that the latest leg of curve flattening has been, to a large extent, driven by front-end selling from Japanese banks and back-end buying from domestic pension funds, and we expect these flows to continue into next year,” said Citigroup strategists led by Jabaz Mathai in a note on December 1.

Under this theory, Japanese banks plowed into 5-year and under duration treasuries and are losing money because of rate hikes. Japan has now given up. Meanwhile, US pension funds, flush with profits, are plowing into long duration treasuries.

The fact of the matter is that pension plans have not recovered to healthy levels despite this rally.

BIS Conundrum

A BIS Quarterly Report makes this claim: Paradoxical Tightening Echoes Bond Market “Conundrum”.

An elusive tightening

Financial conditions have conspicuously eased in US markets over the last 12 months, despite the Federal Reserve's gradual removal of monetary accommodation. After raising the federal funds rate target range for the first time in almost 10 years in December 2015, the FOMC has taken several further steps in that direction.

Since last December, it has raised the target range another three times, amounting to 75 basis points. Finally in October, it started the process of trimming its $4.5 trillion balance sheet, in a move for which it had been preparing financial markets at least since its March meeting.

Yet investors essentially shrugged off these moves. Two-year US Treasury yields have indeed risen by more than 60 basis points since December 2016, but the yield on the 10-year Treasury note has traded sideways. Moreover, the S&P 500 has surged over 18% since last December, and corporate credit spreads have actually narrowed, in some cases significantly.

Overall, the Chicago Fed's National Financial Conditions Index (NFCI) trended down to a 24-year trough, in line with several other gauges of financial conditions.In many respects, the current tightening cycle has so far been reminiscent of its mid-2000s counterpart. At the time, Federal Reserve Chair Alan Greenspan had characterized the fall in long-term yields as a "conundrum".

Greenspan's Conundrum

What do 1999, mid-2000, and now have in common?

Amazing exuberance that nothing can go wrong at precisely a time when everything is likely to go wrong.

I recall full well Greenspan's Conundrum in 2005. Some snips from that 2005 article are pretty amusing.

Greenspan said he was not certain what an upside-down rate structure would mean this time around. Lapsing into characteristic Fedspeak, he responded to a question from the audience in Beijing by leaving himself plenty of room for error, saying, "I'm reasonably certain we would not automatically assume that it would mean what it meant in the past.

In prepared remarks, Greenspan said it was “credible” to think that low long-term rates are signaling economic weakness but said that seems unlikely because "periodic signs of buoyancy in some areas of the global economy have not arrested the fall in rates."

Dot Plot Conundrum

In addition to Greenspan's historic conundrum, we have a current BIS conundrum, and a DOT plot conundrum.

The market does not believe the Fed will hike as much as the Fed believes it will hike.

It's difficult to pin that on Japan.

No Conundrum Then or Now

Economists are in a deep search for evidence that bond market yields are "unlikely" to be signaling weakness.

Since that is what analysts want to assume, it's hardly surprising they found some data that fits the curve.

In 2005 I said there was no conundrum. Rather the bond market was starting to price in a housing-related calamity.

This time, rational individuals note a "Carrot Top" and a Generational Chance to Sell Equities.

When these bubbles burst, treasury yields are going to crash, and from already amazing levels.

Mike "Mish" Shedlock

Comments (18)
No. 1-18
RonJ
RonJ

"In 2005 I said there was no conundrum. Rather the bond market was starting to price in a housing-related calamity." In 2005, congress changed the bankruptcy laws. They knew what was coming. In 2014, the G20 changed the rules for depositors. They know what is coming.

Mike Mish Shedlock
Mike Mish Shedlock

Editor

Excellent points Ron, but "They" does not include Congress or then-president Bush. The bank lobbyists had an inkling for sure.

Roadrunner12
Roadrunner12

" In 2005, congress changed the bankruptcy laws. They knew what was coming. In 2014, the G20 changed the rules for depositors. They know what is coming." I'm guessing its not a stretch to see negative interest rates during the next recession (depression). The banks wont let you take your money out and to top it off, charge you interest for your money which they don't have.

truthseeker
truthseeker

Why not posted Mish?

Advancingtime
Advancingtime

The flip side of this is that we are in a bond market bubble and that those in charge are not fully in control of the situation. Never before do I remember seeing so many predictions of interest rates remaining low forever and a day. Many of us have a problem lending hard earned money out for a long period of time and we should be wary. Rates are based on predictions of future government deficits and events around the world that may or may not unfold as expected. The article below delves into whether the bond market is a bubble phase and the ramifications facing us if it pops.

http://Bond Market Bubble Ending has Massive.Ramifications html

Ambrose_Bierce
Ambrose_Bierce

"Treasury yields are going to crash", you're right. I see in a variety of charts, HYG. Gold which could break the $1000 mark. Crude could lose 50% AGAIN. At least as far as RE goes, asset prices should hold or actually rise as the cost of servicing that debt is once again dropping. The moment when the Feds cold dead fingers are pulled from the levers of the rate hike normalization machine will happen when Congress storms ME (just ahead of the mob that wants their heads). First you screw us by taking away what HC options we had, then you give the rich our tax cut, and then you raise rates to put the crimp on consumer credit spending so we can't put that cancer operation on our credit card. Shame on you.

Cocoa
Cocoa

Also, the new tax plan will impact housing in the bubble states when mortgage interest deduction is limited and state and local property tax deduction is eliminated. NOW it's going to be super expensive to afford housing in CA and NY.

truthseeker
truthseeker

Mish I sure hope you and Lacy Hunt r right about what happens when bubbles collapse. Advancingtime thinks the bond market may b in a bubble, and if he’s right, when some sort of panic, crash begins, the yield at the short end of the curve, from the 2 year note all the way down to 4 week treasury bills will totally collapse, while at the same time the interest rate on the 30 year bond could double or even triple overnight as the dollar crashes giving us a vertical yield curve with the spread getting wider each day. I agree with you and Lacy that debt is deflationary, yet with all the debt, foreign and domestic behind the world’s reserve currency our bond market could indeed collapse imo.

Ambrose_Bierce
Ambrose_Bierce

TS you don't suppose the flight to safety in a market crash would bring down the 30yr as well? The long bond market is like a big ship, it doesn't turn easily, and with government monetizing in 30yrs, settling the trade deficit with China using 30yrs, not to mention all the investors (pension funds) who actually buy them to use as bonds, as well those who buy them to collateralize and speculate on stocks. The dollar will only crash in so far as other currencies are rising, or in this instance crashing. The dollar could well not move one bit and be worth a lot less.

truthseeker
truthseeker

On the other hand if you and Lacy r right, what a wonderful opportunity to be able to aggressively sell off hundreds of billions of treasuries and mortgage backed securities of the 4 trillion plus the Fed sits on as long rates crash!

Ambrose_Bierce
Ambrose_Bierce

the Fed could effectively REFI its outstanding debt at a much lower rate. when rates go negative you you are taking the buyers money and he is paying you to do it. since we can't raise taxes it might get some revenue coming in.

truthseeker
truthseeker

AB just saw your comments. In a true deflationary collapse, the 30 year bond would be very well bid at first having the highest interest rate, as more and more people see signs of weakening economic growth and commodities selling off. I doubt there is an example of things moving in the way I have suggested ~Mish why is it I can’t see what I’ve already said? But what if events don’t unfold as they always have before? So I’m not afraid to say it~what if this time is different? Well our budget deficit is over 20 trillion and on a steeper trajectory due to hurricanes and more spending etc. We have trillions of dollars in our trade deficit just unbelievable. With all these deficits and all this record debt with our Corporations, student loans mortgage ~dammit Mish I can’t refer back to my comments ~record auto loans~so I just make the point that although it may have never happened before, as we head into a recession with all this debt people could very easily loose confidence in going too far out the yield curve no matter how high interest rates have to go to find buyers at 30 years~ the PPT has used considerable leverage to hold things up and they will using it to buy long term bonds this time but will they prevail~not forever!

truthseeker
truthseeker

I’m at Dr haven’t finished trying to make point eyes dialed

Ambrose_Bierce
Ambrose_Bierce

in the one off between fiscal and monetary policy, the fiscal side has weighed in with tax cuts, (revenue holiday? and still holding out on the fiscal stimulus package) which leaves it to monetary policy to make things work, and that likely means a BAIL-IN of investors/ depositors/ and asset owners.

truthseeker
truthseeker

I had to leave before making one last point on this extremely important issue.I certainly hope Mish, Lacy and everybody is right that as the economy gets weaker and commodity prices begin to sell off long term interest rates will fall as they usually do as we begin to slide into a recession with the Fed looking silly having just raised interest rates again. What could change all that with regard to long term interest rates would have to be something horrific happening to cause a panic out of the dollar as people the world over would begin selling long term dollar debt due to something very dangerous we are not at all focused on at the present time.

truthseeker
truthseeker

Mish you know I don’t intentionally bring up comments that are dangerous or irresponsible, tho I guess that’s in the eye of the beholder so to speak. I do miss reading all the comments where you now have ads which is probably what I would do under the same circumstances. At the same time I always want to make comments that r never boring and try to bring up something new to the discussion that stirs emotions without being overly dramatic.

Ambrose_Bierce
Ambrose_Bierce

or TS they can exchange dollar debt for sovereign debt, or debt in some other currency. its hard to imagine a currency contraction because all currencies are priced relative to one another, so if they all shrink, it looks as though nothing has happened, but of course it has

truthseeker
truthseeker

AB This being old news I just wanted to say I enjoy reading all your comments as u make a lot of great points!