Rotten bonds are still open while investors are looking for yield – risks are damned.
By Wolf Richter for WOLF STREET.
The bond market calmed down on Friday. And that was a good thing for crying babies on Wall Street who started hyperventilating on Thursday, when the Treasury’s 10-year yield, after rising for months and accelerating in the past two weeks, had skyrocketed to 1.52% , tripling since August.
As of Thursday, all types of complex leveraged trades were collapsing and forced sales took over. By historical standards, and given the inflationary pressures now under way, yields, even on Thursday, were still surprisingly low. But Wall Street had a cow, for sure.
On Friday, the Treasury’s 10-year yield fell 8 basis points, part of the 14 basis point hike on Thursday, and closed at 1.44%, even higher than it was a year ago, in February 21, 2020.
Yields rise as bond prices fall, producing a world of suffering – reflected in bond funds focused on long-term Treasury bonds, such as the iShares 20 Plus Year Treasury Bond ETF [TLT]; its price fell about 16% from the beginning of August, after rising 3.3% on Friday.
The Fed approves.
The Federal Reserve governors have spoken with one voice about the increase in Treasury yields: it is a good sign, a sign of rising inflation expectations and a sign of economic growth. This is the mantra they repeat.
Fed Chairman Jerome Powell called the increase in Treasury yields “a statement of confidence”.
Kansas City Fed President Esther George said on Thursday: “Much of this increase is likely to reflect growing optimism about the strength of the recovery and can be seen as an encouraging sign of rising growth expectations.”
St. Louis Fed President James Bullard, one of the most passionate doves, said on Thursday: “With growth prospects improving and inflation expectations rising, the consistent increase in Treasury yield over 10 years is appropriate ”. Investors who demand higher yields to offset higher inflation expectations “would be a welcome development.”
They are all singing from the same page: they are dovish in QE and at low rates. But they will allow long-term rates to rise, which is beginning to contain some of the ridiculous foam in the financial and housing markets.
The Fed’s pronouncements on Thursday morning in support of higher long-term yields – when markets clamored for the opposite, more QE, but focused on long maturities to reduce long-term yields – probably also helped to unnerve Wall Street .
But on Friday, the mini-panic calmed down, and that’s a good thing because a real panic could change the Fed’s attitude.
Friday’s 30-year yield fell 16 basis points to 2.17%, erasing the jump from the previous three days. Now it is where it was on January 23 of last year:
The yield curve measured by the difference between the 2-year yield and the 10-year yield was sloping sharply, with the 2-year yield glued in place, and the 10-year yield taking off. On Friday, the spread between the two decreased to 1.30 percentage points, compared to 1.35 percentage points on Thursday, still contributing to the more steep interest curve for this measure since December 2016.
In August 2019, the yield curve for this measure “reversed” briefly when the 10-year yield fell below the 2-year yield, making the spread negative. The yield curve has since increased in a very difficult way:
And mortgage rates have finally started to follow.
The average rate of 30-year fixed mortgages rose to 2.97% during the week ending on Wednesday, as reported by Freddie Mac on Thursday. This does not yet include the Thursday and Friday changes.
The 30-year mortgage rate typically tracks the 10-year yield very closely. But in 2020, they disconnected. When 10-year yields began to rise in August, the mortgage market simply ignored it, and mortgage rates continued to drop from a record low to a record low until the beginning of January, driving the housing market into a super foam.
But then, in early January, mortgage rates started to rise and now rose 32 basis points in less than two months – although they remain historically low.
Note the disconnect in 2020 between the 10-year Treasury’s weekly income (red) and Freddy Mac’s weekly measure of the 30-year average fixed mortgage rate (blue):
In this incredibly frothy and overpriced real estate market, higher mortgage rates will in the end cause some doubts.
And this also appears to be a smile of approval from the Fed. They are not blind. They see what is happening in the real estate market – what are the risks that accumulate with this type of house price inflation. They just can’t say it out loud. But they can allow long-term earnings to increase.
Mortgage rates still need to be updated. The spread between the average 30-year fixed mortgage rate and 10-year yield has been steadily decreasing since the March madness, and at 1.37 percentage points, it is the narrowest since April 2011.
Propagation always reverses from extreme minimums, like this one, towards the average. It can do this in two ways: mortgage rates rising faster than Treasury yields, or mortgage rates falling more slowly than Treasury yields.
High-grade corporate bonds beginning to feel pain.
Yields have increased and prices have fallen across the investment grade spectrum of corporate bonds, although yields remain very low by historical measures:
AA-rated securities yielded an average of 1.81%, according to the ICE BofA AA US Corporate Index, compared to the record low of 1.33% in early August (my glue sheet for corporate bond ratings).
BBB rated bonds – just above junk bonds – have left their torpor in the past two months, with average yield rising to 2.39%, according to the ICE BofA BBB US Corporate Index, above the record low of 2.06 % at the end of December. They, like mortgage rates, continued to fall until 2020, despite the increase in Treasury yields.
Junk bonds are still in la-la-land, with yields close to record lows.
BB rated bonds – the highest rated junk bonds – have left their torpor in the past two weeks, and average yield has risen to 3.45%, according to the ICE BofA AA US Corporate Index, above the record low in mid February of 3.20%.
The average yield on CCC-rated bonds – at the riskiest end of the waste spectrum with a considerable chance of default – has barely risen since the record low in mid-February (7.17%) and is now at 7.27%. In March, income soared to 20%. During the financial crisis, it soared north by 40%.
The Fed smiles at its creation.
The fact that higher-risk bonds still yield near record levels is a comforting signal for the Fed. This means that financial conditions are still extremely easy. All sorts of high-risk companies with crushed revenues and huge losses – think cruise lines with almost zero revenues and losses – can finance their cash burn by issuing large amounts of new bonds to anxious investors looking for yield, no problem.
So far this year, companies have issued $ 84 billion in junk bonds, according for Bloomberg. At this rate, the first quarter will be the largest in junk bond issuance of all time. There is a high demand for junk bonds due to their higher yields – damn the risks. The pursuit of income is in full force. And the overall junk bond market has grown to more than $ 1.6 trillion.
For the Fed, this is one of many signs that the credit markets are still overfumed, even though Treasury yields have soared from record levels to historically low levels. While it has promised to continue with QE and not raise rates for “some time,” it is also telling markets in a unified voice that the increase in long-term Treasury yields is a sign that the Fed’s monetary policies are working as they should. as planned. And these higher long-term earnings are taking some of the froth out of the markets, including, eventually, the housing market – and I don’t think that’s an unintended side effect.
From crisis to crisis and even when there is no crisis. Reading… Fed QE: Assets reach $ 7.6 trillion. Long-term treasure spikes peak, however, Wall Street Crybabies scream for more QE
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