The Treasury rally that oil can't explain

Two weeks ago the yield on the ten-year Treasury note closed at 5.31 per cent, its highest close in about two decades, and talk on Wall Street was of 5.5 per cent and beyond. On October 21 it closed at 5.13 per cent, according to the Treasury's daily yield curve. The fall has happened in a fortnight in which inflation came in hotter than expected, the Fed was openly discussing another rate rise and the government kept borrowing heavily. Bonds should have sold off. Instead they rallied.

The reason lies in the details of how the yield fell. It is not the explanation most investors would reach for first.

Not inflation, but real yields

A nominal Treasury yield can be split into two parts. One is the real yield, the return after inflation, which can be read off inflation-protected Treasuries, known as TIPS. The other is the breakeven rate, the gap between the two, which approximates the inflation investors expect.

On October 5 the ten-year TIPS yield was 2.95 per cent, according to the Treasury's real yield curve. On October 21 it was 2.76 per cent. That is a fall of 19 basis points, slightly more than the 18-point fall in the nominal yield. The ten-year breakeven rate barely moved, from 2.36 to 2.37 per cent. In other words, the whole of the rally came from real yields. Investors did not suddenly decide that inflation would be lower over the next decade. They decided that the real return they need to hold long-term government debt should be lower.

That matters because the most popular explanation for the rally, hopes of a deal between Washington and Tehran that would bring down oil prices, ought to show up mainly in inflation expectations. Oil feeds directly into the breakeven rate. If the fortnight's move had been about crude, breakevens would have fallen. They did not.

A flatter curve

The shape of the yield curve tells the same story from another angle. Short-term yields, which track expectations for the Fed's policy rate, hardly moved. The two-year yield was 4.84 per cent on October 5 and 4.81 per cent on October 21. The three-month bill yield edged up, from 4.22 to 4.25 per cent. The gap between two-year and ten-year yields narrowed from 47 basis points to 32. The thirty-year bond rallied hardest, its yield falling 24 basis points, from 5.66 to 5.42 per cent.

Bond traders call this a bull flattening, and it usually means one of two things. Either investors expect the central bank to keep short-term rates high for long enough to slow the economy, which would lower long-run real returns, or they had been demanding an unusually large premium for holding long-dated bonds and have now decided they were overpaid. Both readings fit the evidence.

The day inflation surprised

The clearest test came on October 14, when September's consumer price figures showed headline inflation at 3.7 per cent, above forecasts. The two-year yield rose three basis points that day, to 4.82 per cent, as traders priced a greater chance of a Fed rise. The ten-year fell two basis points. The next day it fell nine more, to 5.10 per cent, and the thirty-year fell nine, to 5.43 per cent.

That is not the pattern of a market losing faith in the Fed. It is the pattern of a market that expects the Fed to respond to inflation and believes that response will hold inflation down in the long run, at some cost to growth. The minutes of the Fed's September meeting, which recorded that most officials expected another rise "by year end", gave investors little reason to doubt that.

Signs of the cost

The growth side of that bargain is starting to show. Real average hourly earnings fell 0.7 per cent in the year to September, according to the Bureau of Labor Statistics. Pending home sales dropped 7.3 per cent in September, against a forecast of a 0.5 per cent fall, a decline FXStreet attributed to rising mortgage rates. A ten-year yield above 5 per cent sets the floor for mortgage rates, and housing is usually the first part of the economy to feel it.

What could reverse it

None of this means the high in yields is in. The ten-year is still higher than at any point between 2007 and this autumn, and real yields near 2.8 per cent remain high by the standards of the past two decades. The fortnight's rally could unwind quickly if the Fed signals it is less worried about growth than the bond market is, or if a deal with Iran falls through and oil climbs again.

The Fed meets on October 27 and 28. Most traders do not expect a rise there; what matters more is what the committee signals about December. The bond market has already decided that higher short-term rates mean slower growth ahead. If the Fed sounds less worried about growth than the bond market is, long-dated yields could rise again.