Long term interest rates curiously moved sharply higher last week as Fed officials were perceived to have turned more hawkish about raising rates, insisting that September was a live meeting for the Fed. 30 Year Bond Futures (USZ16) on Thursday and Friday went from just over 171 to just under 167 to close out the week. Yields rose from just under 2.21% on Wednesday to 2.39% on Friday, over 18 basis points. Now normally, in an environment of weak growth, if the Fed were to jawbone about tightening, one would expect long rates to go lower as this would imply even weaker growth and hence probably also lower inflation in the future.
So what is going on? Potentially, the market takes the Feds hemming and hawing about hiking rates as a signal that the Fed sees stronger growth and inflation down the road for some reason. However given the Fed’s abysmal history of forecasting anything this signalling effect seems unlikely to be the operative dynamic in the marketplace. Most economic reports are middling to bad other than employment. More likely is that markets are worried about either the ECB or BoJ wavering in their commitment to buying up all the long term debt issued in Europe and Japan.
Why? First, one reason US rates have been dragged lower is the declining rates in Europe and Japan as their central banks buy up all the debt in sight (and equities in the case of Japan). Those seeking positive yield have been attracted to Treasuries because they offer higher yield than sovereign or corporate debt abroad. That liquidity flow means lots of buying of US debt which drags rates lower in the US. But Draghi did not indicate any further expansion of the European program of central bank binge buying after their meeting last week.
Further, there has been talk of the BoJ doing a reverse Operation Twist as a sop to banks and insurers there who are complaining that the low differential between short and long rates threatens their viability because they cannot easily make money under such conditions, especially with nominal rates actually negative out past 10 years. The prospect of having the price insensitive buyers exit the long end and move their buying closer to the front end would mean there is a lot more debt to be soaked up in the higher duration securities resulting in a hike in their yield. And of course a hike in yield in the long end means that price sensitive buyers would have an alternative to stocks. Hence rates rise and stocks fall.