Flat U.S. Yield Curve Is All About Momentum and Algos

It's hard enough to get the public to pay much attention to the market for U.S. Treasuries even in the best of times. And with volatility recently falling to a record low, mom and pop don’t need to check their IRA’s to see what their bond funds are doing. Treasury 10-year yields are trading at 2.32 percent, right at their average for the year. But don't be fooled by the seeming stability, for underneath this placid façade lies a powerful trend.

The yield curve, or difference between short- and long-term bond rates, has been flattening like a pancake, with the pace accelerating the past few weeks and garnering a wave of media attention. Yields on 10-year Treasury notes have fallen to within 69 basis points of two-year yields from about 125 basis points at the start of the year. The last time the gap was this narrow was 2007. This is an important development because a narrower yield curve has historically been associated with a slowing economy. But what's baffling to many is that there are no signs of economic weakness, with growth coming in at a 3 percent pace and the Federal Reserve raising interest rates too slowly to threaten the expansion.

The shrinking yield curve is both rational and a complete mystery. Yields on two-year notes have edged higher in recent weeks, to about 1.63 percent, which is the highest in a decade. That's the part of the equation that makes sense because the Fed has made clear its intent to continue raising rates, including a hike next month to a range of 1.25 percent to 1.50 percent, from the current 1 percent to 1.25 percent. Simple math dictates that short-term bond yields are held captive by the overnight rate, and the money markets show traders are placing the odds of rate increase next month at 90 percent.

While the short-end of the yield curve can easily be explained, it's the long end that is the mystery. The 4-basis-point increase in two-year yields in recent weeks has been overwhelmed by the big 11-basis-point drop in 10-year yields. The move in 30-year bonds is even more remarkable, as yields have dropped 18 basis points to 2.79 percent. That translates into a 3 ½-point increase in prices, or $35 per $1,000 face amount. What makes the move unusual is that there is little evidence that demand is being driven by foreign investors, which has usually been the case in recent history whenever yields fall.