Back in February, we heard about the pent-up demand for new 30-Year Treasuries. After all, pension plans and insurance companies match long-term assets and liabilities, and it had been a long time since they had gotten any fresh debt. As such, the prevailing logic at the time suggested a near constant demand for long debt would keep long-term interest rates in check. However, interest rates have been on a steady march higher since Feb. 22. As a result, the new 30-Year Treasury has lost roughly 9% of its principal value since that time, and its yield is comfortably above 5%. Pent up demand, huh?
The truth of the matter is there just hasn’t been any demand for long-term debt over the last six to eight weeks, for a variety of reasons. Some will point to better than the expected economic data. Others are wringing theirs hands about inflationary pressures. Still others point to a significant drop in foreign demand for Treasuries. The arguments seem endless, and they all have some merit. What didn’t have merit was the long-end’s performance in 2004 and 2005. In essence, in 2006, the bond market is aghast the 30-Year Treasury is acting like, well, a 30-Year Treasury. How long can this last?
Frankly, there is little reason for it to simmer down in the short-term. The technical charts don’t look very promising, as the long-end continues to blast through whatever weak support there is. For their part, institutional investors keep ‘pushing back’ their re-entry level. The 4.70% gave way to 4.75% pretty quickly, which in turn gave way to 4.90% or so. Then, 5% was a psychological barrier the market easily hurdled. Currently, the 30-Year is trading around 5.10% with nothing significant to stop it for a while. So, is this something we will just have to get used to? A 30-Year with a 5% handle? I don’t see why not, at least for now. Why?
For that, we need to go back to the very reason we were so bullish on the long bond in February – pent-up demand. Currently, there isn’t any. The refunding sated many long suffering needs, and pension plans and insurance companies can now hesitate or procrastinate to some degree. There is little reason not to do so. Imagine a pension plan with a 5.25-5.5% discount rate. Why would they want to ‘lock in’ now when rates are moving in the right direction to reduce actuarial assumptions? There is no impetus on that end, indeed. As for other institutional investors, namely mutual funds, the recent steepening of the yield curve makes the long-end something of a wasteland, and portfolio managers are existing barbell strategies simply because they can’t fight the tape any longer. This causes even greater supply ‘out there.’ Foreign investors? That was due to slow at some point. But how long while it last?
The massive rout will soon slow, as we start getting into plan discount rate territory. It will slow a little at 5.125%, and a lot more at 5.25%. 5.50%, if we get that far, will see massive buying, unless the inflation data really picks up from here. In essence, contrary to popular opinion, the issue here is a function of supply and demand. We now have greater supply and lesser demand, and the results are obvious.
What a difference two months can make!
Contributing writer John Norris is senior fund manager and chief economist, Morgan Asset Management, a part of Regions Financial Corp.
