What's going on in the bond market? The yields on long-dated, 10-year and 30-year government bonds are plummeting at a time when both the economy's performance and central bank rate increases should be pushing them higher.
All of a sudden, the long end of the bond market seems to be having a major anxiety attack about the future supply of government debt. So much so that the federal government can borrow long-term money cheaper than it can borrow much short-term money.
In the past, such inversions in the yield curve have signalled pending recessions, occurring at the peak of central bank tightening cycles. But, today's economy shows no sign of impending doom, and the short end of the bond market expects North American central banks to keep tightening for the foreseeable future.
Are we really going to run out of government debt? With mounting budgetary surpluses in the United States, there is growing market chatter about whether Washington will have any debt left to finance when today's bonds mature. This year's surplus looks like it will top $160-billion, and unlike in Canada, all of that goes to debt reduction. Moreover, the Office of Management and Budget (OMB) has recently predicted that if the U.S. economy grows at roughly a 3-per-cent rate (and if the stock market continues to deliver huge growth in capital gains tax revenues), the entire U.S. federal debt will be paid off by 2013.
Interesting projections, but projections nevertheless. Canadian Imperial Bank of Commerce stock rose 13 per cent last month. If it does so every month between now and 2013, I'll be a millionaire.
I wouldn't want to bet on either extrapolation, particularly not the OMB's forecast. A whole lot of things can happen over the next 13 years. If history is any guide, there will be more than enough time for two 1990-style recessions. Throw a couple of those in the OMB's forecasting model, and there will be no shortage of bond supply.
There is even less reason to fear a shortage of government bonds in Canada, even though the Canadian yield curve has mimicked the inversion in the U.S. Treasury curve. While we never know exactly how big Ottawa's surplus really is, we know that no matter how big it is, federal debt reduction is capped at $3-billion a year. At that rate, it will take 150 years to retire the marketable federal debt.
If supply isn't yet a long-run problem, it sure isn't a short-run problem.
The apparent catalyst for today's yield curve inversion, the much-cited U.S. Treasury funding announcement, is no greater a shock to the relative supply of long bonds than last year's retirements. Moreover, even with a buyback of as much as a $30-billion (U.S.) of long-dated bonds and reduced auctions, the Treasury's announcement was no more Draconian in its supply implications than was widely anticipated in markets for months.
So why the inversion now? Never underestimate the herd instinct. Once the Treasury announcement got the ball rolling, the move gained a momentum of its own, particularly when so many fund managers were leaning the other way in their duration call. But can it last? While the 30-year government bond may indeed become a dinosaur, don't count on the broad inversion having much staying power.
Washington and Ottawa might not need to tap the long end of the market, but there are plenty of other borrowers in the economy who would love to issue 10-year to 30-year debt at cheaper rates than they pay on five-year money. So far, investors don't seem to be willing to pay the enormous scarcity premium for long-dated corporate bonds that they seem so willing to do in the government market. Instead, credit spreads between long government debt and long corporate debt have widened steadily, denying corporate borrowers the inversion so prevalent in the government curve.
Until the yield curve inversion extends to other borrowers in the economy, investors shouldn't read too much into it. Whatever the basis for today's contorted curve, you can rest assured that there will be no shortage of government bonds any time soon.
Jeffrey Rubin is chief economist and managing director of CIBC World Markets.