Flat Yield Curve Result of Treasury Market Manipulation Encouraged by Fed-Reversal Unavoidable

For anyone who has been an active participant in the US Treasury market, it comes as no surprise that this is one of the most manipulated markets in the world.  It makes me livid when I hear such off based results for the flatness of the yield curve such as inflation, inflation expectations, hedging demands, slow growth or other outlandish attribution.  There is one reason for such a flat yield curve – manipulation with high volume trading strategies.

Manipulation in the US Treasury market is not a new phenomenon.  This has been taking place for decades.  The recent tactic used is high volume trading especially during low volume periods where the traders are both the bid and offer side of the market.  Such strategies leave a residual position from time to time.  These strategies are usually the most apparent after a long period of Federal Reserve accommodation.  Currently, daily US Treasury trading volumes in the cash and futures markets are approximately 1 trillion.  This is a significant volume especially when you consider half of all Treasuries are owned by foreigners and a fifth by the Fed (these do not turn over) leaving around 5 Trillion in the hands of the public.  Does 1 Trillion turnover a day sound a little high?!

The most recent Federal Reserve accommodation has lasted over a decade.  Not only did it encourage unjustifiable duration risk by bringing the Fed Funds Rate to zero starving investors for yield, but they outright manipulated long-term rates by doing yield curve trades.

The Fed purchased almost 5 trillion US Treasuries and mortgage backed securities geared to taking duration risk out of the market and flattening the yield curve.  They also performed yield curve twist trades, selling short dated securities and purchasing long term securities.  This is not the action of a central bank.  No, the Fed acted like an out of control hedge fund with no price sensitivity nor balance sheet risks.  They loaded up on the most long dated bonds in the worlds history.  Worse, they encouraged other private investors to go along for the ride and accumulate the biggest long dated bond risk ever at the richest prices or lowest yields ever seen.

Now that the Fed has started to raise rates, the impact of their manipulation remains.  The Fed has created a culture of traders that continue to manipulate the US Treasury market to hold long term rates low.  This is necessary or financial pain and a mini financial crisis in the bond market will result. 

Long term rates are arguable 300 basis points, or 3% below a fair value.  Typically, long term bonds trade 3.5% above the rate of inflation to compensate investors for the imbedded risk.  With inflation running between 2% and 3% with no respite on the horizon, that would put long term bonds around 6+%.  Long term bonds could drop in price around 20% for every 1% increase in yield.  It is easy to see the economic devastation that would result if rates normalized in a short period of time.

The Fed has been trying to slowly increase long term yields to limit the potential disruptive financial impact. However, instead of long term rates increasing, they are now lower than typical during a deep depression – definitely not the conditions today.  Today, GDP is tracking above 4%, inflation running over 2%, unemployment as low and labor as tight as it has ever been and the Fed is raising rates.

Instead of selling off and yields going higher, yields for long dated bonds are practically on top of short term bonds.  What this means is you have all the significant additional risk in long dated bonds without any compensation.  This is very reminiscent of conditions during 2008 and the resulting dislocation took a decade to overcome.

The manipulation of US Treasuries is so destructive because the fixed income markets in the US and globally are linked to the value in the Treasury market.  As one market is manipulated to some of the richest conditions ever, the other markets follow.  We now have dangerous conditions in the global bond markets because of the manipulation in the Treasury markets.  Though economic conditions look rather promising for the next couple of years, the expected financial dislocation from a bond market that will eventually correct could have a knock on economic impact.  Though it should be short lived, maybe even just a blip, it has the potential to become troublesome.

Now that the Treasury auctions are at eye bulging levels and the once predictable foreign central banks purchases are less predictable, the accumulative risks will overwhelm the high volume manipulation in the Treasury Markets.   Additionally, the short positions that were in the Treasury market has been squeezed like a lemon and should not be a potential manipulative trade (squeezing the shorts out of long dated bonds) going forward.  This will lead to a steepening of the yield curve when no one is expecting it.  That will make the move much more worrisome – no false attribution to place on the moves.

So buyer beware.  You've been warned.  The flatness of the yield curve is not a natural phenomenon and represents good old-fashioned risk.  Now that cash yields are close to the same yield of long term bonds, it is time to rotate out of all fixed income risk, sit in cash with no opportunity cost and look like a hero as the manipulation in the bond market once again unwinds in spectacular fashion.  Or you can fain ignorance, perform poorly and hope for the best.  After a 10-year gift of spectacular performance in the bond market, who will hold a blip of poor performance against you?  Just be ready for a big blip.