Signs point to more US rate rises as inflation fears refuse to go away
The reissue by the United States Treasury of 30-year bonds last week had deflation alarm bells ringing once again as long-term bond yields fell to well below those available on shorter-dated securities due to the weight of demand from pension funds and insurers for longer-dated assets.
The accentuation of the 'inverse yield curve', widely regarded as a harbinger of deflation, saw investors switching from the short to the long end of the yield curve in the belief that the Federal Reserve had taken the view that inflation was licked and it was therefore through with its pre-emptive rate rises.
In such a scenario, what seemed like a poor yield today could become an attractive return as the US economic cycle turned and dragged global growth down in its wake.
The Fed, in other words, might have gone too far with its rate rises, the market reasoned, and would quickly be forced by mounting statistical indications of a retreat in economic activity into reversing the cycle as it battled to avoid a recession.
In its own research on the relationship between the yield curve and recessions, the Fed had noted that the inversion of the curve 'has predicted essentially every US recession since 1950 with only one 'false' signal, which preceded the credit crunch and slowdown in production in 1967'.
Since 1958, researchers have pointed out, the yield curve has become inverted only eight times, and seven of those times it has been followed by a recession 13 months later on average.
Having flirted with a negative curve since December last year, bond markets have been signalling strong concerns that their worst fears had a growing probability of materialising a year or so down the track, if that inversion remained for any length of time (perhaps 90 days or so, according to researchers).
In Hong Kong, the response from investors to the gathering view that the rate cycle had peaked and was due to turn was on display at the biggest deposit-taking institution in the city, HSBC, active in the market 'receiving' long-dated interest rate swaps.
Driven by demand that is in part the result of regulation and in part spurred by a prudent desire to match assets with liabilities, pension funds and insurance companies were big buyers of the newly reissued US 30-year bonds last week.
That demand quickly took yields on the new 30-year paper down to 4.49 per cent from the 4.53 per cent at which it had been issued, compared with 4.66 per cent for two-year notes. The 17 basis point inverse yield gap underscored the market conviction that rate rises were due to come to an end, presenting holders of the longer-dated paper with the prospect of capital gains as rates tumbled more sharply at the short end of the curve.
From the US government's perspective, the reissue was a striking success, part-funding a record US$181 billion it plans to raise from investors this quarter at highly competitive interest rates.
It was unlikely, however, that Asian central banks were bidders for the paper, said bond analysts. While the region's foreign reserves remain heavily invested in shorter-duration US treasuries, 30-year paper was generally out of bounds for government money managers, they said.
But a week is clearly a long time in bond markets.
Retail data just out in the US resurrected the view on Tuesday that inflation might not, in fact, have run its course, and that under its new management, the Fed might well extend its rate-rising campaign.
A 2.3 per cent increase in retail sales last month was sharply higher than a revised 0.4 per cent rise in December, and the view that American consumers could no longer be relied on to continue driving the nation's economic growth was replaced by a view that consumer spending in fact remained hot enough to be a concern to the Fed's inflation-watchers.
The consequent repricing of US treasuries restored yields to a more normal 'positive' curve, with 30-year paper climbing to a yield yesterday of 4.75 per cent, up from the two-year yield of 4.69 per cent.
In Hong Kong, where rates ought to closely track movements in the US, there was a small tick upwards yesterday in the benchmark three-month Hibor (Hong Kong interbank offered rate), but the ample liquidity in the market continues to keep a lid on rate rises.
However, given the hair-trigger nature of market sentiment at the present time, and the fact that the yield curve remains comparatively flat, it is probably too early to say that those recession fears raised by the inversion of the yield curve have been buried for good.