US bond, signal of new Fed policy

Adding to mounting concerns about the US economy, the yield on 10-year US Treasury notes dropped below the rate of three-month bills last week.

Due to worries over the future economic direction, investors had anticipated that the Federal Reserve could ease its policy rate. But this has not happened, contributing to the inverted yield curve.

The reversal of long and short-term yields on bonds is customarily considered to be a leading indicator of recession. However, many experts are staying cautious, saying it is necessary to wait for more economic indicators before predicting a recession, though it is true that an inverted yield curve is a negative economic signal.

Most of all, the increasing demand for long-term bonds and related US policies are the structural factors dragging down long-term interest rates. The 10-year Treasury note yield fell to 2.44% last Friday, 0.23% below 2.46% – the three-year bill yield.

“It is true that the reversal of yield curves has been a sign of [an upcoming] slowdown in the past,” said a South Korean finance ministry official who closely watches global financial markets. “However, we have to wait and see if it is a temporary phenomenon or if it continues.

“The expansion of demand for long-term bonds is one of the factors that caused this problem, so there should be structural factors as well,” the ministry official added.

The key structural factor referred to is the increasing demand for long-term bonds among insurance companies and pension funds, as the size of their funds continues to increase.

And there is more. A Seoul-based global bond market expert pointed out that US financial policy authorities’ incorrect predictions on bond demand, and the Federal Reserve’s suspension of monetary policy normalization, also contributed to the long-term interest rate decline.

“There is a growing demand for long-term US government bonds, but issuances of short-term bills have increased,” said the expert. “There are technical problems caused by the mismatch behind the interest rate reversal.”

According to the expert, the US Treasury is now making up for its fiscal deficit with short-term government bonds. That action followed a survey conducted two years ago, showing a lack of short-term debt.

However, the demand for short-term bonds has decreased since the US Securities and Exchange Commission’s Money Market Fund regulations were enforced. On the other hand, demand for long-term US bonds continued to rise – particularly, since the Federal Reserve stopped normalizing its balance sheet.

“When the Fed was pushing for the normalization of its balance sheet, it reduced the supply of liquidity in the market by buying only part of the rollover of matured long-term bonds,” the expert said. “But, since the Fed stopped normalizing monetary policy, it has bought all the rollovers which result in a decreased supply of long-term bonds to the fixed-income market.

“In the process of the Fed’s balance sheet normalization, the downward pressure on long-term bond yields eased, but now the long-term bond market is under hard downward pressure,” he stressed.

Former Fed-chair Janet Yellen has also discussed the recent trend in yield curves.

According to CNBC, when Yellen was asked about the inverted yield curve at a conference in Hong Kong, she responded: “I don’t see it as a signal of recession … In contrast to times past, there’s a tendency now for the yield curve to be very flat.

“And in fact, it might signal that the Fed would at some point need to cut rates, but it certainly doesn’t signal that this is a set of developments that would necessarily cause a recession.”

Before last Friday, the Fed’s move to suspend balance sheet normalization had been a structural factor driving down interest rates on long-term debt, the Seoul-based expert said. “But, negative sentiment toward the economy appeared to have led to a fall of 10-year note yields on Friday.”