Investors can’t seem to get enough of U.S. Treasury bonds.
Even though Federal Reserve chair Janet Yellen strongly hinted last week that the Fed could boost interest rates in June, investors went out and bought even more bonds.
The yield on the 10-Year Treasury, which started last week at 2.11%, tumbled to 1.94% during Yellen’s press conference Wednesday. It’s still hovering around those levels. Bond yields fall when prices rise.
Here’s the issue: The exact opposite should be happening. As the Fed raises rates, bond yields should be going up.
Alan Greenspan called this a “conundrum.” He was troubled by this 10 years ago because it made the Fed’s job more difficult.
The former Federal Reserve chair famously (to market and economy nerds at least) used that word in February 2005 to describe the fact that long-term Treasury yields were falling even though the Fed was raising short-term rates.
Current Fed chair Yellen hasn’t spoken about a bond conundrum just yet. But you have to wonder if she’s thinking about it.
The point of raising short-term rates is to try and keep the economy and financial markets from getting overheated. The 10-Year Treasury yield is an important benchmark for consumers as well as investors. It influences mortgage rates.
Red flag? Many financial experts believe that long-term rates were too low for too long in the middle part of the 2000s.
That helped create the real estate bubble that led to the spectacular crash in housing, the Great Recession and a major credit crisis.
Greenspan’s legacy as a market and economy “maestro” has taken a bit of a hit in the past few years as a result. Yellen will want to avoid that happening again on her watch.
But low long-term bond yields are often a sign of economic weakness too. If the Fed is looking to hike interest rates when the market is worried about a slowdown, that could be a problem.
Simply put, the bond market may be telling the Fed that it doesn’t think the economy is strong enough yet to handle a rate hike — even a small one that would barely lift rates from the near zero level they’re at now.
What should Yellen do?
Message to bond buyers: She may find herself compelled to try and “talk” bond yields higher. That’s a trick Greenspan used often.
After his mention of the conundrum in 2005, the 10-Year bond yield went from about 4% to 4.7% in just a few weeks.
Yellen is also going to have to finally unwind the assets the Fed acquired when it first started to buy bonds at the height of the financial meltdown in 2008.
The Fed still has $4.5 trillion in assets on its balance sheet. Even though the Fed is no longer buying new bonds every month, it is still reinvesting the principal payments from the bonds it already holds.
Yellen reiterated last week that the Fed would continue to reinvest in the bond market until it felt that “economic conditions were appropriate after we begin raising rates.”
Unless the Fed stops completely, it will still be one of the forces helping to keep long-term yields low.
It’s not the only one of course. Many foreign buyers — particularly China and Japan — are big holders of Treasuries since the United States is still the safest market in the world to put their money.
Treasuries are even more attractive now that Europe is purchasing bonds in a quantitative easing program similar to what the Fed had been doing up until last year. European bond yields are even lower than the rates on U.S. debt.
But this conundrum can’t last indefinitely. Sooner or later, the bond market or the Fed is going to have to blink.
If the 10-Year yield remains this low once the Fed actually starts tightening, there is a risk that short-term rates will top long-term rates.
That’s something economists call an inverted yield curve. And it’s not good. That’s happened before every recession in the past 50 years.
