Bond Curve Normalizes Following Sub-Prime Meltdown

There has been a very interesting divergence in the direction of short term vs. long term treasury yields since the market turbulence of February and March:



The yield curve had been severely inverted for many months, but with long yields rising and short yields falling most of the curve has normalized.

The uptrend for long yields and the downtrend for short yields have been very steady and well defined:




My best guesses at what has been happening behind the scenes are:
1. Primary Dealers want higher long bond yields and lower short term rates.
2. Excess liquidity has created high demand for T-bills for money market accounts.
3. The opening of new carry trade positions has hit a fevered pitch in the past 3 months. Short term treasuries were the highest yielding and most liquid part of the curve, so much of dollars purchased with borrowed yen ended up there. The Yen has been pounded down by new carry trades and now is threatening to break through long term resistence in the 122/Dollar range:



Demand created by carry traders for leaves banks with very little desire for cash from the Fed. The repo rate has been well below the fed funds rate since Mid-April and Fed repos have been low.

Meanwhile, foreign investors are still buying very large amounts of Treasury Bonds, probably because theiry the ones with the most dollars in need of a long term investment vehicle. Just about all of the Indirect bidder orders get filled as they still don't seem to be very price sensitive. (Indirect bidders are largely foreign central banks and overseas hedge funds.)

Primary Dealers, on the other hand, make up the biggest percenatage of bids and have (by far) the most unfilled orders at each auction. What they as a group are willing to pay effectively determines the interest rate coming out of auctions. They're generally the ones who are hurt the most by an inverted curve because their traditional business is to borrow money at short term rates and lend it out at long term rates.

Therefore, I expect primary dealers are the ones who are normalizing the curve on both ends as they seek to boost their profits in a time when they're facing large losses from mortgage defaults. This may help them in the short run, but it is having the effect of raising interest rates for new mortgages and refinancings. This will only put more pressure on the housing market as homes become less affordable to new buyers.

We'll see where rates go from here. There should be some resistance for 10 and 30-year bonds at 5%. That may put a lid on rising rates for a little while. Housing was in bad enough shape as it is. If rates break out above 5% that could be a nail in the coffin.