Curves Ahead

Is it 1987? Given how much we are talking about the bond market these days, we should all be reading Tom Wolfe’s “Bonfire of the Vanities.” (Skip the movie version.) As a self-described bond geek, I am here for it.

So, what the heck is going on with the bond market? Let’s just say that our relationship status with bonds these days is complicated.

We’ll start with the yield curve. If you plot a line showing today’s short-term interest rates (interest rates on loans that mature in less than a year) all the way through to long term interest rates (for example, a 30-year treasury bond), the line slopes upwards to the right. Like this (on May 28th):

That is, you earn a higher interest rate for bonds that have a longer maturity. (Here’s why.)

What has been happening lately is that the line is getting steeper. An easy way to see this is to subtract the (higher) interest rate of a 10-Year treasury bond from the (lower) interest rate of a 2-Year treasury bond. (Bond aficionados call this the 10-2 Treasury Spread.) Lately, that difference has been growing. When the difference between short and long rates increases, we say that the yield curve is steepening. And boy is it ever:

What’s going on? Confusion mostly. Conventionally, when bond traders expect that there will be more inflation in the future, longer term interest rates go up. If I lend you money today and I expect that by the time you get around to paying me back prices will have risen, I am going to charge you extra for that loan. Tariffs are one reason why traders see inflation in the future.

The other reason for higher long-term interest rates is the federal deficit…or rather, where it is headed. Traders can see that if the administration persists in the fiction that they can meaningfully reduce the gap between government spending and revenue without raising more revenue (e.g., taxes), more money will need to be borrowed. That means the Treasury issuing more bonds. And what happens when the supply of anything increases? (Pause while you madly flip through your ECON 101 notes…) The price falls. And for bonds, when the price falls, the interest rate automatically goes up. (Again, I refer you here.)

The recent downgrade by Moody’s of US bonds from the highest Aaa tier was an interesting talking point for a day, but not terribly meaningful in the grand scheme of things. The other rating houses stripped the US of that status a few years ago, and no one is really fearful of the US defaulting on its debt. (Madly throwing salt over shoulder…) More interesting is the story of whether international buyers are starting to shun US debt. The jury is still out on whether that is really a thing or not.

So why do you care about any of this? Because the amount you pay for a home mortgage, a student loan, a car loan, or your credit card is derived from the market rate for longer term treasury bonds. The other reason you need to care is that the more the US government pays to service its debt, the less money is available for good stuff like, I dunno, health care anyone?

You may hear talk of whether the Federal Reserve could or should cut interest rates but understand that that is a conversation about short-term rates. The Fed can influence short-term rates, but the bond market rules the long end of the spectrum. (And FWIW, the Fed is not sure what to do about those short-term rates. They are afraid of inflation too.)

If you are not a borrower, but are a lender (that is, you are investing in bonds, perhaps through a bond fund in your retirement account), what does this mean for you? In the short term, probably not a heckuva lot. Perhaps you will see the value of your bond fund fluctuate more than you are accustomed to if it is a fund that owns longer term bonds. But unless you have a reason to sell your investment (for example, you are retired and ready to take distributions from your retirement account), this should not be a grave concern. If you are in distribution mode, then you will find more comfort investing in the shorter-end of the yield curve where bond prices usually do not fluctuate so much. (Once again, here.)

Oh, and 1987? That year the average yield of the 30-Year treasury was 8.59%. Mortgages were above 10%. So, let’s not go back to the eighties even if “Bonfire” was a pretty good read about the bond market.

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