Wait – This Is Normalization?

We know that the Fed is in the process of “normalizing” rates and looking to start shrinking the $4 trillion+ balance sheet loaded with bonds that they have amassed over the past few years. It would seem logical that this would impact rates much more than it has. In fact, conventions wisdom would consider the recent actions and outlook as hawkish that should be pushing the short and long end of the yield curve higher – but that is not what is exactly happening.

While the short-end has been rising over the past two years+, the long end has actually come in. In other words, the yield curve has been flattening. The shortest of maturities are the most susceptible to the Fed’s rate hikes, but the long-end should be moving higher as they seek to unwind the longer-term bonds that they own.

Notice on the chart above that the bonds with maturities greater than 7 years are yielding less than they did at the end of 2015. This does not seem right with what we know about the economy and the Fed’s intentions. So, why is this happening?

There are many explanations for this phenomena, but the most likely culprit is that there is a simple arbitrage that continues to be active where bonds in most other developed nations are yielding less and therefore are sold in order to purchase longer-term U.S. fixed income. Since yields are actually negative on many EuroZone bonds, there is no reason to invest there while the potential for a much higher relative yield persists in “safe” U.S. government backed bonds. Look at the difference in the EuroZone Government Yield Curve below.

Compare the two charts and ask yourself which you would rather be invested in at this time.

As the ECB continues to state that they will need to continue with massive QE programs and ultra low (and negative) rates, there is  no advantage of owning EuroZone bonds with the potential for a great deal of downside in the future. That leaves very few options available for bond related portfolio and the natural beneficiary is U.S. fixed income.

In a vacuum, without the above rationale, some may think that the curve is implying that there is a very big concern out there that has yet to be realized. While this is possible, for now it does not seem a probable as compared to the simple explanation above.