Does this sound like a good backdrop for buying long-term Treasury debt?Your central bank is all but begging to see higher inflation. Your central bank implies it will let inflation run hot before it will raise interest rates. Over $4 trillion of fiscal stimulus will be financed with the issuance of Treasury debt. There is an expectation that there is going to be an unleashing of pent-up demand that leads to above-trend economic growth.
Simply put, that's not a compelling setup. It screams "interest rate risk."
Why, then, aren't longer-dated Treasury securities getting sold in earnest? Granted they have faced increased selling pressure in the latter half of 2020, but it hasn't been a "rush-to-the-exits" kind of move. The 10-yr yield bottomed at 0.50% in early August and has been moving higher in a measured way since then, sporting a current yield of 0.94%.
That's a logical move based on the backdrop presented above, yet in a certain sense it also defies logic based on the backdrop presented above.
What it reflects perhaps is an appreciation for intervention risk -- that being the Fed holding the power to flip the switch on its Treasury purchases (which will be "at least $80 billion per month...until substantial further progress has been made toward the Committee's maximum employment and price stability goals."). In other words, the Fed could concentrate more of its purchase power on longer-dated securities whenever it so chooses and/or it could even increase how much money it uses to purchase Treasury securities.
The Fed sees this "twist" as a tool that remains at its disposal -- and it might choose to use it if long-term rates move up too quickly and threaten to derail the recovery effort that the Fed hopes will invite higher inflation.
Still, the Fed is undoubtedly in favor of some curve-steepening that reflects confidence in the recovery effort. The issue, as it relates to any intervention, isn't so much the direction as it is the pace of the steepening. A measured pace that shores up market confidence in the recovery is acceptable. A fast pace that upends market confidence is not -- or so we think.
Either way, there seems to be ample interest rate risk in the mix that should temper buying interest in longer-dated securities absent some unforeseen shock that materially alters the vaccine-infused recovery outlook.
Accordingly, with interest rate risk promising to be a prominent risk for a long time to come, a short-duration strategy is apt to be a preferred strategy that lends relative strength to securities with a shorter time to maturity.
(Editor's Note: The next installment of The Bond Column will be posted the week of January 11.)at email@example.com