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 pohare@briefing.com