Feb 23, 2023

Yield curve inversion - why long end not rising up?

Asking the credit forum since trying to understand this. Explain this to me as you might a small child or a golden retriever, it wasn't my brains that got me here, I assure you of that.

30 year Treasuries are paying 3.98% https://fred.stlouisfed.org/series/DGS30

3 month Treasuries are paying 4.72% https://fred.stlouisfed.org/series/DTB3

I get it that some long term investors like insurance funds need to duration match so they have to buy the longer end, but why would an investor take on duration risk on the long end to get LESS return? Shouldn't it stand to reason that the long end should start rising also at some point? At what point does investor preference change, or is it more a function of the Fed pushing short term rates up more so than the long end reacts?

 

Long end rates are pinned down by an underlying assumption that 1) The Fed will be able to get inflation under control (<=2%) in the long run and 2) Will be able to do so with a long run Fed funds rate around 2.5% (term premiums, rightly or wrongly, are still negative at the long end of the curve).

Frankly, long end Treasury rates are propped up by balance sheet constraints and such - 30 year swaps are at a material negative spread to Treasuries and helps illustrate the faith that markets have in the Fed being being able to return to a target inflation environment with a more "normal" Fed funds rate. Whether or not these pan out is another question. Long-end rates would likely rise materially if markets lose faith in either of the above two.  

 

Also remember money plows into those safer ‘defensive’ assets when economy deteriorates and we enter into a recession. After J.Powell rhetoric market began to price in higher for longer with Fed #1 goal being to curb inflation even if that means unemployment and a recession, thus demand for 30s will rise if we do enter into a recession. At that point FI investors can look to sell some of those longer-dated treasuries at higher prices. This is just one factor anyways but you was on-point also with liability mismatching etc.

 
StonksAlwaysGoUpAlso remember money plows into those safer 'defensive' assets when economy deteriorates and we enter into a recession. After J.Powell rhetoric market began to price in higher for longer with Fed #1 goal being to curb inflation even if that means unemployment and a recession, thus demand for 30s will rise if we do enter into a recession. At that point FI investors can look to sell some of those longer-dated treasuries at higher prices. This is just one factor anyways but you was on-point also with liability mismatching etc.
This is tenor agnostic though - 30's are a higher (duration) risk investment than 6-month bills after all. Inversion now doesn't really reflect a higher demand for 30's because it's a lower risk investment, more so that investors at the 30-year point willing to lock a yield much lower than current short-term yields due to it being relatively more attractive than their expectations for evolution of rates over 30 years (plus whatever risk compensation they require if rates evolve differently to that expectation).
Once we enter a recession it's the 6-month that will rally much more strongly than the 30-year as markets price in Fed cuts. 
Also note that Bill curve is currently dislocated due to debt ceiling fears - a lot of that dislocation is concentrating around the 6m point so that yield is currently a bit artificially elevated.
 

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