Lot’s of hand wringing these days about the flattening yield curve. We still maintain our position that the signal from the bond market is significantly distorted due to the global central bank intervention (QE) into the bond markets. See here and here.
Most of what is happening with the U.S. yield curve is technical. Sure, traders can get a wild hair up their arse, believing the economy is slowing and try and game duration by punting in the cash or futures markets. Given the small relative float of the U.S. Treasury bond market, however, it doesn’t take much buying to move yields. In the words of economists, the supply curve of outstanding Treasuries is very inelastic.
This is illustrated in the following chart. The combined market cap of just Apple and Amazon at today’s close is larger than the entire the float of outstanding Treasury notes and bonds that mature from 2027-2027. We define float (US$1.16 trillion) as total Treasury securities (2027-2047) outstanding (US$1.73 trillion) less Fed holdings (US$575 billion).
Now consider you started the year with, say, a hypothetical $3 billion portfolio of Amazon, Apple, and Treasury notes and bonds, each with a 33.3 percent weighting.
Given the rise of Apple and Amazon stock prices just this year, the current under weight in your Treasury position relative to the start of year would force an additional purchase of US$226 million of bonds to get back to the 33.33 percent weighting. The allocation effect of a stock bull market or bubble on the bond markets can be a powerful source of demand.
This is a classic case of a positive feedback loop between two markets. The allocation effect and the increased demand for bonds lowers the interest rate making stocks fundamentally more attractive as the rate to discount corporate cash flows declines. This drives up stock prices ergo another allocation effect on bonds.
Here’s to hoping that in the next decade we, and the policy makers, don’t look back at this period with regret realizing we got the signal from the yield curve entirely wrong. In hindsight, it is always so obvious.