A New Conundrum?

Chairman Greenspan called the failure of bond yields to rise as the funds rate rose in 2004-06 a conundrum.  The failure of bond yields to fall as stock prices tanked last week could be viewed as a new conundrum.  Over the past nine years, Treasuries could be relied upon to rally whenever stocks faltered.  If, however, we consider the fundamentals now confronting bonds, their recent behavior is not that puzzling.

Until recently, bonds could celebrate a drop in equity prices because central bank policies could be relied upon to keep rates low.  Economies were growing too slowly and inflation was too  low.  Now, the U.S. is at full employment and the rest of the world is much healthier.  Central banks everywhere are reducing or planning to reduce stimulus.

In the U.S., the impact of the Fed’s rate increases and balance sheet reductions is exacerbated by an acceleration of Treasury borrowing.  Tax cuts and spending plans are pushing the Federal deficit to over $1 trillion in fiscal year 2019–double the 2017 deficit.  Until this year, deficits were shrinking.

A relatively flat yield curve and a big increase in Treasury issuance at a time when the Fed is buying fewer notes and bonds is a much different set of fundamentals than in the conundrum year of 2004.  If the curve was as steep as in 2004, perhaps bond yields might not rise very much as short term rates trend higher.  But with the curve already quite flat, it is not puzzling that fears of higher short-term rates push yields higher and total returns negative on the longer maturities.

When bond fundamentals were benign, it was easy for investors to buy Treasuries when stocks faltered.  The psychology was that the Fed would remain supportive.  That is not the psychology today.  Rallies in stocks still elicit selling of longer Treasuries, but declines in stock prices are apparently not sufficient to offset the negative bond market fundamentals.  Perhaps it is not a new conundrum–merely a new set of fundamentals.

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