Market Commentary

O brave new world, That has such people in’t! ~Miranda to Prospero in "The Tempest"
Ken Leech
Chief Investment Officer

Executive Summary

  • Fears of accelerating growth combined with Fed commitment to “taper” asset purchases has led to a consensus bearish sentiment on rates. But two months into the year, growth is tracking the 2%+ level.
  • As policy has begun normalizing, so has the yield curve. The challenge fixed-income investors are facing is that we have never before experienced this enormity of monetary policy experimentation, and don’t know what the withdrawal will look like.
  • Dramatic spread widening in the summer of 2007 signaled impending financial system risk. The extraordinary acceleration of the widening of these spreads through 2008 foretold the impending crash. Today, similar spreads are suggesting quite the opposite.
  • In three cases following extended periods of Fed easing, the yield spread has moved above 100 bps. The very wide level of this spread currently presents an attractive opportunity.

Bond markets have rallied strongly this year. Fears of accelerating growth combined with the Federal Reserve’s (Fed) commitment to “taper” asset purchases had led to arguably the most consensus bearish sentiment on rates in many years. Instead, however, two months into the year, growth appears to be tracking the 2%+ level that has characterized the five years of the recovery. Inflation remains near the lows of recent years. Optimism about global growth has also dimmed. Fears of a downshift in Chinese growth and the severe challenges of many emerging market economies, not to mention the complete disarray in Ukraine, have dampened expectations.

Ever since the Fed indicated in November its intention to re-commit to a tapering process (which commenced in December), the Treasury yield curve has flattened sharply (Exhibit 1). Over this period, five-year notes have risen 13 basis points (bps) while bond yields have actually fallen 33 bps. As policy has started to normalize, so too has the yield curve. This represents the new challenge fixed-income investors are facing: we have never before experienced the enormity of monetary policy experimentation that has ultimately expanded the Fed’s balance sheet to $4.1 trillion, so we don’t know what the eventual withdrawal will look like.

Exhibit 1
Yield Change (20 November 2013 to 28 February 2014)
Source: Bloomberg. As of 28 Feb 14

Our view is that moderate growth and low inflation will continue to contain any meaningful rise in longer Treasury yields, even if and as the Fed very, very slowly removes policy accommodation. Indeed, this is what the flattening yield curve appears to be suggesting. We think this trend will continue.

Fed Policy—Breezy Historical Review

Let’s review the monetary policy of the crisis and post-crisis years in order to get a sense of whether the yield curve will look much different going forward. The minutes of the Fed’s meeting immediately after the Lehman collapse were recently released. In those minutes, Ben Bernanke commented that the Fed’s (low) 2% funds rate policy seemed to be working quite well. His perception, and that of many others at the time, was that 2% was an ultra-low policy rate that was too low relative to the Fed’s forecast of growth, but necessary (and sufficient) to keep the crisis contained. Consider for a moment just how spectacularly different that thought process is from today. We are no longer experiencing the financial crisis to which Bernanke and his colleagues were obviously referring and which the 2% funds rate policy was meant to address, yet keeping rates at zero indefinitely to help the economy is still the order of the day. (Indeed, we sometimes joke about the fact that we have a meaningful number of young employees who have never known any other funds rate but zero!)

Consider, too, for a moment, how different this same thought process is from that period of time preceding the crisis. The credit markets were flashing near catastrophic warnings, but the concept of “below 2%” just wasn’t really considered. That (mis)judgment was almost instantly followed by the financial meltdown that led to the TARP initiative in just days. Exhibit 2 shows the history of senior bank yield spreads versus Treasuries in the US and the similar spreads for Europe since 2007. As spreads widen, the market’s judgment is that the probability of default is increasing. The dramatic widening in these spreads in the summer of 2007 signaled impending financial system risk. The extraordinary acceleration of the widening of these spreads through 2008 foretold the impending crash. In Europe, the financial crisis was nearly revisited in 2011 as the European Central Bank kept tightening even as bank bonds (and peripheral debt) were plummeting.

Exhibit 2
Senior Bank Spreads
Source: Barclays, As of 26 Feb 14

Back to the Future

Today, similar spreads are suggesting quite the opposite. The enormity of the Fed’s response after Lehman, and the continued determination to prevent another downside break by using heretofore unheard of measures over the last five years, have together been crucial in allowing the financial system to stabilize and finally heal. Current bank spreads are now at their lowest level since 2006. With the systemic risk threat currently off the table, the Fed’s unwind of emergency policy has commenced. Investors accustomed to never-ending carry and roll down now have to gauge how much they believe interest rates will rise relative to forward rate expectations.

This makes the purchase of short and intermediate securities more treacherous. It also completely changes the dynamic of yield curve investing. With the Fed seemingly on hold at zero rates forever, an investor was incentivized to play for a yield curve steepener. The carry and roll down per unit of duration of an intermediate security was much better than that of longer maturities, and the downside price risk was well anchored. This led to a massive steepening of the yield curve. But while forward expectations of the path for fed funds may be well defined for a number of years, the forward expectations between 10s and 30s are reasonably opaque. Historically the spread between these two points has been narrow (Exhibit 3).

Exhibit 3
Sources: Federal Reserve Board and US Treasury. As of 21 Feb 14

Since the bond auction process of 1977 to the present, this yield spread has averaged 35 bps. In three cases following extended periods of Fed easing, this spread has moved above 100 bps. Subsequently the spread has contracted sharply. Over a much longer period of time (1953-2014),1 the persistent flatness for this relationship is evidenced by the average spread of 24 bps. The very wide level of this spread currently presents an attractive opportunity.

An overweight position to the long end of the yield curve benefits not only as a standalone position, but also has powerful portfolio benefits. As we illustrated in a previous paper,2 the benefits of long bonds as a portfolio diversifier to credit and other spread product positions has been historically very effective. Long bonds have very substantial positive convexity attributes. They are crucially important in the foundation of long-dated liability matching portfolios.

A much lower growth environment has resulted in bull market curve flattening in each episode over the last five years. Periods of accelerating growth have led to bear market curve flattening like last summer. Certainly, the scenario of an overly accommodative Fed that fails to correct even after inflation accelerates is hazardous. A more relevant risk to our flattener scenario would be a continuation of the not-too-hot, not-too-cold, Fed on perma-hold environment of the last nearly five years. We think that time has passed. We look for a much flatter long end of the Treasury yield curve.

History may not prove to be a precursor for future markets. The Fed’s inflation fighting regime clearly kept the yield curve in a flatter position than one in which the Fed may tolerate a higher inflation rate. Perhaps the Fed will not only succeed in getting higher inflation, but will simultaneously persist in keeping short rates artificially low, promoting an ever steeper yield curve. Such fears were certainly voiced as recently as a year ago. But the distance from the crisis, the amelioration of systemic risk, and most importantly, the Fed’s tapering decision in a low inflation environment suggest that a more normal outcome lay in store.


  1. Focuses on a slightly different spread metric with slightly different current value.
  2. Ken Leech, Market Commentary, April 2013
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