Authors of this article are Chris Probyn, Chief Economist, James Kramer, Portfolio Manager, Interest Rate Strategies, and James Mauro, Portfolio Manager, Interest Rate Strategies.

Chairman Greenspan's recent reference to the behavior of the world bond markets as a “conundrum”¹ highlights the unusual behavior of the Treasury market during the early phase of the latest tightening cycle. Specifically, the yield on the 10-year Treasury note has fallen by over 20 bps while the Fed has raised the funds target by a cumulative 150 bps, causing an excessive flattening of the entire US yield curve.

Why has this happened, especially given the fundamental backdrop of robust economic growth, accelerating inflation, rising oil prices, high budget deficits and a weaker dollar? The short answer is a confluence of forces, including the transparency of monetary policy, contained inflationary expectations, pension reform, foreign central bank demand for US securities, a new government deficit financing strategy, and the shift to floating rate debt.

The Transparent Fed
Chairman Greenspan and his colleagues have been remarkably clear about their intentions in this interest rate cycle. For example, when inflation was a little too low for comfort during 2003, Greenspan stressed that the Fed could remain “patient”. Then, as confidence in the sustainability of the recovery grew through 2004, he stated that policy accommodation could be removed at a pace that was “likely to be measured”. Such clear communication steered market expectations toward a string of 25 basis point rate hikes, and the Fed subsequently delivered on this expectation. Consequently, the monetary authorities are perceived to be in control of the situation, creating a sense of calm at the long end of the market.

Contained Inflationary Expectations
Although the Open Market Committee has raised the funds target six times since June 2004, the statement accompanying its decisions has consistently declared the risks to inflation as balanced, rather than skewed to the upside. Moreover, actual inflation has been well behaved, with the core implicit price deflator for consumer goods – the Fed's preferred measure – continuing to hover around 1.6%, comfortably within the 1.0-2.0% range that Federal Reserve Board Governor Bernanke defines as price stability.

Even the surge in energy prices, which would normally be expected to steepen the yield curve by generating additional inflation uncertainty, contributed to flattening pressures. This outcome occurred because the Fed's hard-won credentials as an inflation fighter caused investors to focus on oil's demand-reducing, rather than cost-increasing, effects. Such a sanguine attitude effectively anchors inflationary expectations, suggesting a flatter yield going forward.

Pension Reform
Pension plan under funding has raised speculation about tighter regulation of defined benefit (DB) plans. Although it remains unclear exactly what form that might take, it seems most likely that the level of premiums payable to the Pension Benefit Guarantee Corp would be tied to the degree of risk in a plan. To avoid higher premiums, plan sponsors would need to reduce risk by establishing a better asset/liability match. This, in turn, boosts the demand for fixed income assets at the expense of equities. While no changes have been made to date, the market is clearly anticipating a move. Moreover, with only $670 billion (37% of DB assets) in long-dated Treasuries and only $50 billion (2.8% of DB assets) in long-dated Treasury Inflation Protected Securities (TIPS), there are obviously supply-demand imbalances further out on the maturity spectrum large enough to influence the shape of the yield curve. Indeed, long bonds are flattening to every point on the curve and could eventually invert.

Foreign Central Bank Demand
Overseas central banks have become ever-larger buyers of dollar-denominated securities simply because of the increasing US current account deficit. This trend has been accentuated lately as dollar weakness has led some central banks, most noticeably in Asia, to make additional dollar purchases in order to prevent excessive or even (in some cases) any appreciation of their own currencies. As these dollar reserves are recycled back to the Federal Reserve Bank of New York for safekeeping, they automatically become a demand for US securities. In the past, foreign central banks typically bought one- to three-year Treasuries, but recently they have expanded their benchmarks to include sovereign, agency, and even corporate debt out to ten years. The sheer level of foreign central bank demand and its shift into longer-dated securities is considered a major contributor to curve flattening over the last year. Indeed, it is estimated to have cut yields in the ten-year sector by between 50-100 bps.

A New Budget Financing Strategy
In its latest Budget and Economic Outlook, the Congressional Budget Office projects substantial federal government shortfalls through at least 2010. While this suggests a return to the bad old days when the market obsessed over foreign participation in the Treasury auctions, particularly of longer-dated securities, the pattern of issuance will be different going forward because the 30-year Treasury bond has been discontinued. Indeed, when the long bond was dropped from the financing calendar in 2001, 10- and 30-year bonds flattened by 25 bps on perceived scarcity value of the newly discontinued security. The size and pattern of the Treasury's ongoing financing requirement is likely playing an important role in the shape of the yield curve. Almost 60% of all Treasury issuances will be three years or less in 2005 compared to 50% in 1999. Moreover, with the average maturity of outstanding issues moving to under three years, this should create supply/demand imbalances consistent with a flatter yield curve.

More Floating-Rate Debt
The composition of the mortgage universe has changed over the last couple of years. In particular, hybrid adjustable-rate mortgages have become increasingly popular with home owners. Indeed, this type of product has grown from 5% to 20% of outstanding mortgages since 2001. At the same time, the demand for and issuance of floating rate corporate debt has increased. These moves from fixed to floating rate instruments place upward pressure on short rates, and downward pressure on long ones. And while the switch in preferences does not come close to explaining the excessive yield-curve flattening to date, it certainly adds to the growing list of contributing factors.

Before jumping into a “flattener”, however, it is important to realize that because it has been one of the most profitable trades over the past eight months, it has now become overcrowded by real money and leveraged investors alike. This is creating volatility in curve spreads not present in the underlying yields, making the trade increasingly unpalatable for the faint of heart.

¹ This refers to the testimony of Chairman Alan Greenspan at the Federal Reserve Board's semiannual Monetary Policy Report to the Congress, before the Committee on Banking, Housing, and Urban Affairs, US Senate February 16, 2005.

This material is for your private information. The views expressed are the views of Chris Probyn, James Kramer, and James Mauro only through the period ended April 1, 2005 and are subject to change based on market and other conditions. The opinions expressed may differ from those with different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results.

Posted On: May 12, 2005