Wary About Carry
As time ticks down to the first Fed hike next year, the market will be more and more wary about the “carry” between shorter-maturity-treasury yields and the expected cost of financing them.
By Steve Van Order, Fixed Income Strategist
Last week, markets with higher risk (i.e., risk-on markets) started off on a firm tone on perceptions that Fed Chair Yellen's speech was more dovish than expected. Our analysis of the speech found no notable change in her views regarding conditions in the labor market—it was simply the wording emphasis that set it off. The latest FOMC projection has the median Fed funds target rate at the end of 2016 at under half of a pre-crisis normal neutral rate1, and the Fed has stated that it is committed to keeping the policy target rate lower than normal for some years to come.
Time is ticking down to a first lifting of the policy rate in 2015, assuming no serious economic stumbles, and that keeps the market alert. The two-year T-note yield is still under 0.5%. Just one rate hike (to a 0.5% Fed funds target) would eliminate the yield spread with that two-year T-note. That is, the "carry", the profit margin, for short-rate funded accounts such as banks would be eliminated. So the market is wary about carry, and expresses this primarily by pushing around the short-intermediate yields. In the absence of a crisis environment, this is classic market action at this point in the policy cycle in response to economic data surprises and comments by Fed leadership. The Fed's eventual exit strategy will include ending reinvestment of principal and interest payments on Treasury and MBS holdings, draining excess bank reserves, as well as policy target rate hikes.
As the week progressed, and there were no major surprises, the risk-on markets stayed in the lead as Treasury yields drifted upward. On the policy front, while the European Central Bank (ECB) did not cut target rates, President Draghi made dovish comments in his press conference, including strengthened forward guidance for very low policy interest rates and potential for further rate cuts or even QE as next easing steps. As a result of these comments, the yield chase in Europe accelerated. The five-year Spain government bond yield fell below the five-year U.S. Treasury for the first time since 2007. Moreover, the Bank of America Merrill Lynch euro area high yield index yield is now well below its U.S. counterpart making U.S. bond yields relatively more attractive.
Rounding out the week was a U.S. employment report that came in close to consensus. Treasury yields drifted down a bit and there was a modest downtick in expected Fed funds rates out in 2015 and 2016. The significant curve flattening discussed last week was corrected a little bit. The yield curve, measured from five- to 30-years was 188 bps versus 181 the prior week. As the path toward Fed policy normalization continues in April, we expect yield fluctuations similar to last month's, but with a slight upward direction.
1. That is, a "Taylor rule" rate.
This commentary represents the opinions of the author as of April 4, 2014 and may change based on market and other conditions. These opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information. Calvert may have acted upon this research prior to or immediately following publication. In addition, accounts managed by Calvert Investment Management, Inc. may or may not invest in, and Calvert is not recommending any action on, any companies listed.