It has been a hectic week for fixed income markets and Friday offers the chance for more action in reaction to the upcoming employment report. The government 10-year yield has reversed by 12-basis points from its early-week peak at 2.72%. The two-year government note has also seen its yield dip, but given its sensitivity to monetary tightening by the Fed, has moved by less. As a result and as you can see from the below chart, the yield curve is undergoing a bearish flattening. The distance between twos-and-10s has narrowed to 220 basis points having started the year at 265 basis points when the yield on the 10-year started out at 3.02%. Back then Treasury traders were trying to unravel the Fed’s actions having just started (unexpectedly) to taper its bond-buying.
While stocks continue to take a rosy perspective on an economic rebound, yields continue to decline. One reason why this might be happening in the face of expectations of an improving economy is the volume of corporate issues coming to market recently. Apple(NYSE:AAPL) issued $12 billion in debt this week just to fund its dividend payout. When bonds are priced to the curve, Treasurers pass the “rate-lock” risk to dealers who now have to hedge through Treasury purchases as the new issues come to market. The combination of dealers chasing bond yields lower out of necessity to hedge corporate issuance and an inevitable squeeze on existing short positions might be forcing yields down lower than is reasonable as investors stare down the barrel of the nonfarm payroll report.
Chart – Curve flattening between two-and 10-year yields
Whether corporate issuance is or is not the culprit, the yield curve is flattening significantly. The market is coming to terms with the Fed’s tough task of explaining its tapering process, determining the take-off point for short-term interest rates and feeling out its equilibrium level for short-term rates over a vague time frame. The April ISM manufacturing report showed another dip in the closely-watched prices paid index, which is another positive sign for price developments. Yet while activity is rebounding, the Fed is not winning the inflation half of its dual mandate in terms of restoring prices back to the 2% threshold. Bond yields could fall further and the curve could flatten more should the employment half of its mandate not pick-up soon.