Yesterday morning, we highlighted a fascinating observations made first by Deutsche Bank, which showed just how much of an outlier the US yield curve has become relative to all other G10 nations: “The US 5y yield is now higher than any available 10y yield in other G10 countries.“
The US 5y yield is now higher than any available 10y yield in other G10 countries: DB
— zerohedge (@zerohedge) May 16, 2018
The full observation, originally made by Deutsche Bank’s macro strategist Alan Ruskin, was as follows:
In what is a very unusual experience, not only does the US have the highest 2y, 5y and 10y nominal and real yields in all of G10, but the US’s 5y yield is now higher than any available 10y yield in other G10 countries. Even the US’s nominal 3y yield (2.73%) is higher than all G10 countries’ 10y yields, except Australia’s 10y (2.82%).
Visually, this is shown by this sampling of G10 yield curves, in which the US is obviously the purple curve at the top:
Today Bloomberg had a similar take on this dramatic flattening of the yield curve, noting that while US 2Y TSYs offer nominally higher yields than 10Ys in Canada and Italy, US 3-Month Bills yield more than 60% of 10-Y yields across the DM space.
Needless to say, the flattening across the US curve has been astonishing.
For reference, another Deutsche Banker, Jim Reid, reminded us yesterday of the last time the 10Y was where it is now, at ~3.10%: for comparison’s sake, this was back in 2011 when 2yr yields were around 0.4% and 30yr yields were around 4.3% so as Reid puts it, “today’s level are a testament to how much flattening the curve has still seen in recent years as 10yrs have returned to the same level.”
Meanwhile, back in 2011 10yr Bunds were also around 3% while yesterday they did climbed 3.3bps to 0.641%, “so that continues to be one of the most crazy global financial markets” in Reid’s humble opinion.
The important point, according to Ruskin, is that “investors can take much more limited duration risk on US fixed income, to get the same yield as anywhere else in the G10 world.“
Duration risk, related to stretching out the yield curve, is seen as a particular issue in this cycle as Central Banks exit extreme accommodation. In the US, duration risk relates particularly to a few difficult to quantify factors, including: i) an unusually large expected increase in Treasury issuance (of nearly 3% of GDP between 2017 and 2019) related to both the Fed’s balance sheet reduction and the large fiscal expansion; and, ii) because the US Administration is attempting to put a stop to large official reserve buildups that are related to currency manipulation. These recycled official flows into US Treasuries, acted as ‘a bond put’ when the USD was weak.
And while the US yield curve is starting to move under the parameters of conventional economic forces such as treasury supply and demand, places like Europe and Japan are still toiling under an entirely different set of factors, namely central bank “jump risk” or concerns that central banks will no longer anchor the long end, causing another taper tantrum and/or VaR shock.
In the EUR area and Japan, the critical duration concerns relate to how aggressive Central Bank easing has severely distorted fundamental bond and credit value, and the uncertainties this fosters about ‘jump’ risk as and when they exit such distortionary policies. This exit risk particularly applies to Japan’s yield curve targeting regime.
Of course, anyone who has watched the yield curve and the USD recouple in the past month – literally, ever since the PBOC cut RRR on April 16 – will know that the sharp move in rates has been matched by a similar move in the dollar. This has manifested itself by the sharp spike in short-end yields which have led to an effective pancaking of the US Treasury yield curve: here’s Ruskin:
In the past it has been remarked, how high US short-term rates and the flatness of the US yield curve has been a deterrent to hedged foreign flows into US Treasuries, most obviously from Japan.
The flip side of this is that as long as the expected USD exchange rate has shifted broadly neutral, US short-term yields are certainly high enough relative to a G10 peer group, to be extremely attractive without the need for investors to stretch out the curve and assume duration risk.
Ultimately, this boils down to a feedback loop whereby perceptions of a relatively stronger economy manifest in changes in the yield curve, which in turn leads to capital inflows, and a stronger dollar, are prompting the Fed to tighten further, creating expectations of even higher short-term rates, and even stronger inflows.
As per the above, the expected exchange rate is crucial to the US attracting unhedged bond flows that are then USD positive, and the compelling duration weighted yield advantage is one important factor tipping the scale in favor of self fulfilling positive USD expectations.
And while the feedback loop is quite effective on its own, especially with yields at other G10 economies frozen by QE or NIRP, the one catalyst that can breach it is a repricing of economic expectations. For now, the US is seen as the cleanest dirty shirt, especially after China’s easing on April 17 which launched the aggressive repricing higher of the dollar and 10Y yields (maybe it was Beijing’s warning shot in the ongoing Trump-Xi trade war?)
All that would take for the recent move to reverse violently, would be one or more economic indicators disappointing, or Fed heads suggesting that tightening in the US has gone on too far. Until that happens, however, keep buying that USD and cut duration on the curve: after all if the difference between 2Y and 10Y paper is just ~50bps, why not?