And Now, Let’s Hear from the Bond Market

Last week’s market action was dominated by a sharp increase in interest rates, particularly in the five year, ten year, and thirty year Treasury maturities. Underlying the action was an unusual circumstance in the short term money markets – the difference between the yield on the two year Treasury and a key bank rate shrank to as low as it has been since the depths of the pandemic panic last spring. This time the declining spread is driven by a distaste for the massive amount of debt that the US is pumping out -not a disruption in liquidity. In other words, because the markets need to absorb huge Treasury issuance as we cover costs for the pandemic and other needs, traders are saying ‘no way’ to all that debt. Instead, for the time being, they are parking assets in cash and short term bonds. In an ominous sign, the Treasury auctions last week did not go well, with tepid demand at best.

Too, the Fed has been planning to jettison cash off its balance sheet – an event that could cause short term rates in the US to go negative, particularly given the preference for investors to stay short right now. All that demand stands to drive yields down even more.

This is the first time since 2008 that we’ve felt that rates might continue rising for a time. Huge budget deficits might be coming home to roost, causing investors to demand more yield to finance our government. What remains to be seen is whether this trend has staying power. In the past, higher rates have caused the economy to slow, which then reins in activity and puts the brakes on the rising trend. This time, though, we intend to pump a lot of money into the economy, which could swamp the effect of higher rates for a while.

In the meantime, investors with income appetites should pay attention. We might have an opportunity to lock in higher yields shortly.