The credit markets

Something very big appears to have occurred throughout the U.S. long-term credit markets since early May. The yield on the benchmark 10-year Treasury note recently reached its highest level since 2002. America’s inverted yield curve suddenly “disinverted” for a brief period. Meanwhile, conflicting inflationary signals abounded. And former Federal Reserve Chairman Alan Greenspan’s famous conundrum may soon be a memory.

Is the period of cheap long-term money about to end? And if so, will the era go quietly? Or will there be convulsion throughout the financial markets, simultaneously afflicting mortgage brokers, home buyers (and sellers), insurance companies, banks, private-equity firms, hedge funds, companies selling junk bonds, emerging markets and the U.S. government, all of which became addicted to cheap money?

Before reviewing what has happened in recent weeks, let us first appreciate how extraordinary the era of cheap money has been. For the 2002-06 period, the yield on the 10-year Treasury note averaged 4.4 percent. During the same period, consumer price inflation averaged 2.64 per year, generating an average real (inflation-adjusted) interest rate of 1.76 percent. By comparison, over the previous 20 years, the average percentages for the 10-year nominal yield, the change in the consumer price index (CPI) and the real interest rate were: (1997-2001): 5.66 nominal, 2.46 CPI, 3.2 real; (1992-96): 6.6, 2.88, 3.72; (1987-1991): 8.43, 4.42, 4.01; (1982-86): 10.97, 3.84, 7.13.

Early last month, the markets for U.S. Treasury debt securities and mortgages were meandering along as they had been since late summer. On May 10, the benchmark 10-year Treasury note yielded 4.65 percent, only a quarter point above the 2002-2006 average. On the same day, Freddie Mac reported the weekly average fixed rate for a 30-year mortgage was 6.15 percent, little changed since the beginning of the year and down a quarter point from September. Then yields on both instruments began to climb steadily from one week to the next. By June 7, the 10-year note broke through the 5 percent level, and Freddie Mac’s average 30-year fixed-rate mortgage climbed to 6.53 percent. In the bond market, these are very big jumps over a very short period.

But the excitement was just beginning. As the Economist deadpanned this week, “In the days following June 7, bond investors had a traumatic experience.” Having closed at 4.97 percent on June 6 (reflecting a healthy jump from 4.65 percent four weeks earlier), the 10-year yield reached a startling 5.33 percent during trading on June 13 before retreating toward 5.2 percent. Meanwhile, Freddie Mac’s benchmark 30-year fixed rate hit 6.74 percent, 0.6 percentage point above its May 10 level. Over a mere five weeks, the price of a long-term fixed-rate mortgage (i.e., its interest rate) jumped nearly 10 percent, while yields on 10-year Treasury notes increased about 12 percent.

The yield curve had become inverted in October 2006 when monthly average yields on 10-year notes and 30-year bonds fell below the averages for the overnight fed-funds rate and the interest rate for the 3-month Treasury bill. For a while recently, the yield curve regained its normal upward slope. The famous Greenspan conundrum — the inability to explain stable and even falling long-term rates in the face of the Fed’s rising overnight interest rate, which increased from 1 percent in June 2004 to 5.25 in June 2006 — suddenly no longer existed.

Inflation’s role in the bond market trauma has been indeterminate. While the overall CPI has been accelerating in recent months, its crucial core component, which excludes food and energy, has been decelerating. Meanwhile, inflation-indexed Treasury bonds have shown little change in inflation expectations in recent months. There has, however, been some recent evidence of Asian central banks losing their taste for Treasury securities. As their demand declines, the prices of the securities fall, and their yields, which move in the opposite direction, rise. If an acceleration of inflation were to compound an ongoing Asian retreat, yields could really take off, igniting a contagion throughout the financial markets. On the other hand, as Morgan Stanley believes, the rise in bond yields may be as benign as the natural reaction to an acceleration in the growth rate of the economy.