(949) 706-7777

Positioning For The Coming Capitulation

When I scan the market for “distortions”, nowhere is the situation more odd from a historical context than in the level of global yields.  Indeed much has happened that was unforeseen, even unimaginable a few years ago. Many sovereign yield curves (and even corporate bonds in many countries) are negative, and maybe even justifiably so.

Many authors, including this one, have written to explain this peculiar state of affairs. Reasons include demand from investors for scarce “money-good” securities for their “insurance”-like properties (government bonds are basically insurance policies again global financial meltdown, but not against inflation); the need to minimize tracking error to indices that are composed of these sky-high securities; and plain and simple outright purchases by global governments that are crowding out investors. Many of these dynamics are still in place.

This bond market rally in recent years has certainly been more hated than even the equity market rebound and rally from the 2008 lows. If there is any truth in the adage that the markets collectively go to the point of pain for most investors in the shortest amount of time, we are probably nearing a crescendo and then an inflection point. What might this look like? Can we get ahead of it?

We need look no further than the grinding flattening of the US yield curve as an indication of what an impending capitulation in the bond markets might look like.


With the 10 year treasury at 1.8%, and the 2 year treasury at 0.88%, the spread is for the first time below 1% in almost a decade.  The Fed has recently signaled that they will be raising rates, i.e. all else being equal, there is a bias toward the short end of the curve to rise in yield.  On the other hand, economic growth is slowing as the recovery gets long in the tooth, and the 10 year in the US looks like a bargain compared to negative yields in many countries where long term yields looked pegged close to zero or even negative.

Yes, there is currency risk for a foreign investor to purchase US treasuries, but given the relatively tight bounds within which currency markets have been moving, the currency risk might indeed be something that some foreign investors would accept to earn a bit more yield on their portfolios.  Not only do US treasuries provide extra yield for investment, but as the world’s reserve currency, they also provide an insurance benefit against a global financial catastrophe.

Going back to the yield curve, note that in both 2000-2001 (Internet crash), and 2007-2008 (global financial crisis), the yield curve had already begun to demonstrate a similar flattening behavior and eventually an inversion, where long term yields fell below short term yields.  We can also bring in the difference between the 10 year yield and the 30 year yield.  The 30 year treasury at 2.6% is another 0.8% above the 10 year treasury, and the difference between the two also seems to be on a path toward further flattening.

While the difference between the 2 year and the 10 year is driven by Fed policy and economic activity, the difference between the 10 year and the 30 year is driven additionally by inflation expectations and  demand for long term insurance and investment that can only be found in long term treasuries.

Leave a Reply

Your email address will not be published. Required fields are marked *