PSI acompanha ganhos europeus no fecho da semana. BCP sobe mais de 3%

[Karamba]

Não estava à espera deste super comportamento do bond market que teve início em meados de Abril. Os 460 pontos o 30Y pareciam (me) à prova de tudo. Está bem ..., mais uma vez estava a ver mal.

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Will the Yield Curve Continue to Flatten?

Richard Berner and Amy Falls (New York)



Conviction that the yield curve will continue to flatten has driven the U.S. Treasury market sharply higher in the past four weeks. The "bull" flattening has accompanied one of the most dramatic bond-market rallies in fifteen years: Ten year Treasury note yields have declined by 60 basis points since the end of April, while yields on three-month bills have hardly budged. Four key forces are behind this flattening: Belief that the Fed will do whatever it takes to fight deflation, rising deflation risks, a global thirst for yield, and so-called "extension" trades in which investors are forced to chase yields as they decline. These forces could take yields on 10-year Treasuries to 3% or even lower in the next several weeks. Eventually, the yield curve will re-steepen as yields rise, but market participants must sense that the Fed is truly winning the war against deflation before a meaningful rise in long-dated yields occurs.

The most important factor driving the flattening is the belief, valid in our view, that the Fed will do whatever it takes to fight deflation. Fed officials have been talking openly about their resolve to fight deflation since last November, but only recently have they acknowledged the risks. In his April 30 Congressional testimony, Fed Chairman Greenspan drew the line in the sand, noting: "With price inflation already at a low level, substantial further disinflation would be an unwelcome development..." Fed pronouncements since have underscored both the Fed's concern that inflation might be too low and their resolve to arrest its decline.

The Fed could employ three tools to help achieve that goal. Officials have explicitly discussed two of them, namely, both buying notes to bring yields down and keeping short-term rates low--possibly lower than today--until deflation risks have passed. While unstated, because the Fed leaves dollar policy to the Treasury, we believe that officials also have a third tool: They are implicitly blessing a weaker dollar to promote easier financial conditions and to help restore pricing power for Corporate America (see "The Dollar and Monetary Policy," Global Economic Forum, May 2, 2003).

A second key force that is flattening the yield curve is that deflation risks have risen in the context of falling "core" inflation and still sluggish growth. Over the past three months, core inflation measured by the Consumer Price Index has fallen from 1.5% to just 0.4%, and while the data may overstate the decline, there is no mistaking the direction. Moreover, while the conditions are falling into place for an economic acceleration, there is little sign that the U.S. or global economies are reviving from a period of sub-par growth. As a result, deflation risks have risen, likely to one in four from 15% a few months ago (see "Reappraising Deflation Risks," Global Economic Forum, May 20, 2003).

Market participants don't yet see a full-blown deflation scare, however, let alone a deflationary event. TIPS spreads have narrowed somewhat over the past month, but remain at levels above any reasonable threshold of deflation concern at about 160 basis points. And a deflation scare should widen credit spreads as profits and credit quality erode, volatility rises, and investors flee risky assets. But risk spreads have remained extremely tight; for example, spreads on the five-year credit default swap for Morgan Stanley's 100-name Tracers portfolio of investment grade bonds has widened by about 10 basis points to a still-low 80 bp over the past month.

A global thirst for yield in a world of low nominal growth and single-digit returns is a third force that has flattened the yield curve. Investors burned by more than three-years of a bear market in stocks have by and large used the equity-market rally as a chance to sell stocks and buy more bonds, thus extending the long bull market in fixed income. The bursting of the equity bubble fostered risk aversion, evident in the negative correlation between stock and bond prices. At a minimum, therefore, fixed-income securities offered diversification. And as in 1993, the Fed's policy of keeping short-term rates low for an extended period makes financing longer-term notes profitable and promotes a flatter yield curve as investors reach for yield.

Many fear that the global thirst for yield and aversion to risk threatens to reverse the U.S. rally as investors either flee U.S. debt for the safety of higher yields elsewhere or demand higher U.S. yields as compensation for the risks of a weakening dollar. Lately, however, U.S. yields have actually fallen slightly as the dollar has weakened, reinforcing our view that overseas rates are more likely to decline towards ours, not the other way around. Just as global investors' reach for yield here is flattening the U.S. yield curve, so too will the reach for yield abroad pull overseas rates down toward ours. And with the world's most powerful central bank declaring war on deflation, the idea that the Fed would tighten monetary policy to defend the dollar seems farfetched. As a result, a dollar crash in today's global context is highly unlikely.

The fourth and final force flattening the U.S. yield curve is paradoxically that the yield decline itself forces some investors into so-called "extension" trades that reinforce the rally. When mortgage borrowers refinance at lower interest rates, they shorten the duration of mortgage investors' portfolios. In turn, that forces investors to buy Treasuries as a hedge. More generally, market participants believe that pension funds and others with long maturity liabilities will scramble for yield as interest rates decline if they haven't already done so. In essence, the decline in yields has exaggerated the so-called asset-liability mismatch by increasing the present value of pension liabilities. While short-term cyclical forces are forcing some folks into "buying duration," we agree with our colleague and pension expert Michael Peskin that the pension asset-liability conundrum won't go away quickly.

These powerful forces may continue to flatten the yield curve and drive yields lower for now. But is the Fed with all this monetary stimulus just creating a new bubble, this time in bonds that will eventually burst? Eventually, the yield curve may re-steepen; after all, that would be the hallmark of a truly credible deflation-fighting Fed. But bond prices may first have to go towards bubble levels before market participants believe that the Fed is winning the war against deflation. At that point, investors may start to think policy is inflationary and yields will begin to incorporate a bigger inflation premium. For the Fed, we suspect that event would elicit a sigh of relief rather than a moment of anxiety.

There certainly is a case for a darker side to this story of opportunistic reflation. Blessing a weaker dollar, implicitly or not, seems at first blush to be fraught with peril. After all, we have huge external financing needs, approaching $2 billion daily, and our low domestic saving rate implies that something's got to give. The goals of Treasury Secretary Snow's new de facto neutral dollar policy, as our colleague Stephen Jen terms it, are to allow market forces gradually to weaken the dollar and incidentally pressure European and Japanese policymakers to adopt more stimulative policies. But we'd agree with our colleague Steve Roach that this is a high-wire act that may encounter stiff resistance (see his accompanying Forum, "The Heavy Lifting of Global Rebalancing"). A war of 'competitive devaluation,' as Japan and the U.S. seem to be waging, could create unintended consequences. After all, we cannot all have weak currencies, and such currency wars have in the past been thinly veiled moves toward protectionism. In resisting current account adjustment, however, the Japanese authorities may also be trying to piggyback on a different battle, namely the Fed's fight against deflation. They may not succeed without significant structural reforms. For now, however, they and Japanese investors seem willing to finance a large part of the U.S. current account deficit by buying U.S. dollar-denominated assets.