Reflexivity And Why The Fed Must Sell The Long End
The yield curve is flattening like a pancake.
Tightening cycles tend to do that.
Furthermore, the effective float of 10-year and longer U.S. notes and bonds is relatively small and greatly distorts the bond market signal. We have written about this several times.
…how small the actual float of longer-term marketable U.S. Treasury securities is available to traders and investors. The data show the Fed owns about 35 percent of Treasury securities with maturities 10-years or longer. Note the data only include notes and bonds and excludes T-Bills.
The Fed’s holdings combined with foreign ownership of longer maturities — more than 1-year — exceeds 80 percent of marketable Treasuries outstanding. The Fed combined with just foreign official holdings, mainly, foreign central banks, is 65 percent of maturities longer than 1-year. Thus, almost 2/3rds of tradeable Treasuries longer than 1-year are held by entities with no sensitivity to market forces. – GMM, March 2017
Given the small float of tradeable Treasury notes and bonds, the market is subject to massive short squeezes if it gets too offside and rapid ramps if traders algos try and game duration.
Information Positive Feedback Loop
Many in the market, we fear, are being hoodwinked by the flattening yield curve, however. It’s purely the result of technicals and not economic fundamentals.
Nevertheless, some still look to the badly distorted bond market as a signal of the health of the economy and act accordingly. Such as delaying capital spending; becoming more risk averse; and cutting back on consumption, for example.
A flatter yeld curve also makes bank lending less profitable.
This could thus lead to what George Soros calls “reflexivity” where the negative, but false, signal from the bond market actually causes an economic slowdown or leads to a recession. So much for efficient markets.
Recall the famous line of one prominent market strategist during the dark days of the great recession,
“ We’re in a depression. That is what the bond market is telling us.”
Or the ubiquitous, “what is the bond market telling us?” Come on, man!
The Fed Needs To Start Selling Longer Dated Securities
It would, therefore, behoove the Fed to sell some of its longer dated Treasury holdings to steepen the yield curve.
The follwing table shows the Federal Reserve’s holdings of U.S. Treasury securites and the total Treasury outstandings for each year. This table does not include T-Bills.