Why the interest rate markets are moving the way they are and what you can do about it
On Friday, May 22, something relatively amazing happened in the U.S. Treasury market and no one really seemed to notice.
According to the U.S. Treasury Department’s official website of daily rates, the yield on the benchmark 30-year U.S Treasury bond closed at 1.40% that day; the exact same yield that it closed at the day previous.
OK, an unchanged yield in the Treasury market is not all that exciting, nor is it obviously without precedent. In fact, based on the last seven years, the yield on the 30-year bond goes unchanged from one trading session to the next on average of 25 days per year. That’s over a month’s worth of trading days a year.
It’s easy to understand, subsequently, the lack of visible fanfare back on that May day. However, what makes this fateful Friday a relative oddity is that it was just the first time in 2020 the 30-year ended the day unchanged, the second longest span of continuous yield activity since the U.S. government began benchmarking maturities in the late 1970s.
And not only have the unchanged days been more than few and far between this year (at the time of this writing, the 30-year still has only one unchanged day), the yield changes themselves are nothing short of extreme. For instance, over the previous seven years, the 30-year has averaged a yield change between 10 and 14 basis points roughly six times a year.
Not even halfway through this year and 2020 has already had nine of them. This type of heightened volatility hints at a deeper issue at hand with liquidity in the interest rate markets and that invariably leads to handiwork of longer-term economics playing out in the near-term.
Liquidity tends to be taken for granted, especially in the Treasury market. Municipal bond investors can be a bit more sensitive to liquidity, however, given the relative uniqueness and overall variety of the products in that market. Yet, the overall connection between market liquidity and economics is less understood. Most relegate the relationship to a solely a reactionary one. Something to the effect of, when the economy’s “bad” liquidity is too and vice a versa. Unfortunately, something as complex as economics of potential output can never be that simple and that is because of the nature of the leverage that binds them together.
The economy can rely upon financial leverage to effectively pull forward enough of its potential so as to maintain an acceptable output gap (one that’s neither too wide or too narrow). After all, it is only when the economy grows consistently within an acceptable distance of its potential that the Fed’s dual mandates of full employment and stable prices can be met.
Meanwhile, liquidity is a necessary function so as to employ that leverage. In the terms of Archimedes, liquidity is the fulcrum when using a financial lever to move the economy closer to its potential. However, that fulcrum of liquidity becomes less reliable and more suspect to failure as potential slips further away.
From a long-term economic perspective, the economy has been failing to maintain a close enough gap to its potential for the better part of the past two decades. As evidenced by weak GDP expansion and soft income growth, the economic cycle has turned into something of an economic oval with GDP taking on a more congealing aspect.
To put that into context, it might be helpful to think of the 1970s when the output gap was too narrow and inflationary overheating was produced until enough space was made between the real economy and its potential. The current widening of the output gap, though, is the opposite of that and is a function of potential growing faster than the real economy can handle via surplus productivity.
In contrast to a depression or a recession, the real economy currently suffers from a procession; a slow and methodical move forward albeit at a pace increasingly below its potential.
This economic procession means the economy turns to falling prices or deflation as a source of (re)leverage and gives a colder shoulder to the discovery and engineering of financial leverage. With a lesser need for financial leverage, liquidity can easily turn into li(quit)ity, here today, gone tomorrow, coronavirus or no coronavirus.
The impact of COVID-19, in terms of the general state of financial market liquidity is all effect and no cause. As horrible as it is, COVID-19 did not exist this past September (that we know of) when the Fed had to provide liquidity support in the repo market.
Nor was COVID-19 around in 2016 when the Fed warned of significant product-slack; an inventory glut that is still pervasive (more a form of business liquidity).
And COVID-19 certainly cannot be blamed for the fact that labor only earned 58 cents of every dollar consumed in the 2010s compared to 65 cents for most of the 20th century.
Has the virus amplified and accelerated the situation? Has it made it even harder to pull forward that exceptionally large amount of potential that has dominated the U.S. economy?
Unequivocally, yes. But liquidity has been becoming li(quiti)ty for long-term economics for almost 20 years now.
Subtlety, no matter how brief, speaks volumes in volatile markets. The fact that the yield on the 30-year has spent only one day unchanged although almost halfway through the calendar year says more about the state of the economy and liquidity than any actual yield level could right now.
In economics, when the output gap is abnormally shaped, we’re told to expect price volatility. It stands to reason that in this economic procession, when the gap is widening, that interest rate volatility will continue to produce what was once considered abnormal results.
Liquidity, unfortunately, will have a larger tendency to quit on investors than not.
While not much exists to do anything about it in the short-run, understanding and appreciating the root cause of that illiquidity can prevent investors from quitting on themselves.