Twistin' the Yield Away

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Treasury yields staged a spectacular collapse last week after the Federal Open Market Committee's anxiously anticipated meeting. What made the bond markets shudder wasn't what the U.S. central bank's policy-setting panel did, but what it said.

"There are significant downside risks to the economic outlook," the FOMC said on Wednesday afternoon, in a statement released after the end of its two-day meeting. That set off paroxysms of selling of risk assets, from global equities to commodities, and a flight to the safety of U.S. government securities and the dollar.

As widely expected, the Fed said it will purchase $400 billion of longer-term Treasury securities, to be offset by the sale of shorter-term paper in order to lower long-term interest rates. While the size of the so-called Operation Twist 2.0 was somewhat bigger than predicted, the impact on the long end of the yield curve was electric. The 30-year Treasury bond rallied ferociously, sending its yield crashing through the 3% barrier, touching 2.738%, the lowest since December 2008, in the wake of the financial crisis. The 10-year benchmark yield hit 1.672%, within a basis point (1/100th of a percentage point) of the historic nadir reached in the 1940s, when the Fed explicitly pegged government-note yields.

The collapse in bond yields was the flip side of the plunge in stocks and commodities, suggesting markets weren't being driven so much by policy changes as by the inability of policy makers to deal with the unequivocally worsening economic prospects around the globe. The never-ending European sovereign-debt crisis hangs over the region's banks, and threatens to drag down the economy (but may force the European Central Bank to reverse its restrictive policy). China's economy continues to slow, as indicated by the third straight monthly contraction in manufacturing—news that accelerated the slide in stocks and commodities early Thursday. As if to underline the Fed's downbeat assessment (which was echoed by the International Monetary Fund), the Economic Cycle Research Institute's U.S. weekly leading indicator has deteriorated to negative 6.7% growth rate, the worst since this indicator began to roll over in early May.

The markets' reactions couldn't be wholly laid on the Fed's actions, which Lacy Hunt, chief economist of Hoisington Management—an Austin, Tex., fixed-income manager with $4 billion under management—terms "the least harmful they could have taken." The Fed "is in its predicament from its past policy mistakes," which he contends "clobbered modest-income households" by raising the costs of necessities such as food and energy. The resulting drop in real, inflation-adjusted incomes has put the economy "on the cusp of a recession."

Hunt says Hoisington's portfolios are positioned with an ultralong duration of 18 years, to take advantage of further declines in Treasury bond yields as the U.S. economy goes through the needed deleveraging to undo the excesses of decades of credit excesses. The Fed's purchases will equal 90% of the Treasury's long-bond issuance through June 2012, says Gluskin-Sheff's chief strategist, David Rosenberg; he thinks that will push the 30-year yield "to historic lows of 2% by the time this rally is fully complete."

By week's end, the 30-year yield was 2.90%, down 47 basis points on the week and 30 basis points above its record low, hit in January 2009. To put that in perspective, the popular iShares Barclays 20+ Treasury Bond exchange-traded fund (ticker: TLT) gained 5.6%, nearly what the major stock-market indexes lost. Through Thursday, the ETF returned 32% since the beginning of the year, according to Morningstar. The 10-year benchmark note yield ended Friday at 1.84%, down 22 basis points on the week. The Fed's anticipated sale of shorter maturities lifted the two-year-note yield five basis points on the week, to a still incredibly low 0.22%.