Although the longer term trend, in place since July, is for lower bond yields, the quarter ended with bond yields only slightly higher, as the market reassessed the likelihood of rate cuts from the Federal Reserve.
The US yield curve also completely inverted, with two-year Treasuries yielding more than 30 years at one point. Historically, an inverted yield curve often precedes a recession, but in this case, the US economy should be heading for a soft landing.
The market had been steadily pushing back the expected date on which the Fed will start easing interest rates. February’s sell-off saw the market reverse its view, pricing rate cuts from the Fed back into the market, on the expectation that the Fed would step in to bail out falling markets. The Fed should keep short-term interest rates on hold, at 5.25 per cent, for the rest of 2007.
In this rate cycle, despite the Fed hiking policy rates from 1 per cent to 5.25 per cent, longer term borrowing rates have not been affected. Thirty-year mortgage rates in the US are at lower levels than they were two-and-a-half years ago, when the Fed started hiking.
Despite recent turmoil in equity markets, there is good evidence that the US economy is headed for a soft landing, which should allow the Fed to leave short-term interest rates on hold, and prevent bond yields from breaking lower, out of their current range.
The risk to this scenario, is that the housing market slowdown spills over into other sectors. And while the recent sell off in the sub-prime mortgage market has sparked a general repricing of risk, the sell-off is largely technically driven, and isolated. As long as the jobs market remains robust, consumers should keep spending.
What does that all imply for bond yields? Ten-year Treasury yields should stay in a 4.40 per cent to 4.8 per cent range over the next month, with the “housing slowdown versus. inflation risk” dichotomy keeping the bulls and bears in balance and the market rangebound – despite February’s equity market correction. Further volatility is expected at the front end of the yield curve as the market continues to reassess the probability and timing of Fed rate cuts. And with company balance sheets looking strong, a soft landing should keep defaults in check, which is supportive of credit spreads.
Elizabeth Para, CFA, is senior product engineer at State Street Global Advisors, UK.
