Even though Europe is on the forefront of global bond news these days, I’d like to revisit the US Treasury market. Specifically, I’ll look at the Canadian-US bond spreads, which tell an interesting tale of Fed purchases and US deficit fears.
First, the Canadian over US government bond spreads for two longer term issues, 10yr and 30yr in chart below, have been falling for some time. Today (Jan. 10, 2011), the 10-yr Canadian Treasury over the 10-yr Treasury spread is around -12 basis points (bps), i.e., the Canadian 10-yr bond is 12 bps lower than the US 10-yr. The 30-yr spread is roughly -86 bps.
The recent divergence of the ‘spread’ between these two spreads presents a bit of a conundrum, since the two have more or less moved in lockstep.
Note: in the chart above, each dotted line represents the period average for the 30 calendar day (30-c.day) moving average spread of similar color.
The conundrum is this: the 30-yr spread has deviated well below its 2002-2011 average of 8 bps, while the 10-yr spread is sitting roughly at its average, -13 bps. But this is not a conundrum if you consider recent US policy, holding all else equal.
One the one hand, the Federal Reserve is concentrating its bond purchases in the long end of the curve, primarily below the 10-yr maturity. According to the NY Fed, 23% of the $600 bn will be allocated to the 7yr-10yr part of the curve, while just 4% will support the 17yr-30yr end. Therefore, and holding all else equal, the CAN-US spread proxies somewhat the effects of Fed policy in the bond market. The Fed is supporting the 10-yr spread roughly at trend(Section II in chart above), while contemporaneously raising inflation expectations relative to that in Canada.
On the other hand, without Fed support the 30-yr spread is pricing in not only rising inflation expectations but also an increasing US sovereign risk premium relative to that in Canada. This is a similar premium that was attached to Canadian sovereign debt in the early- to mid- 1990s (Section I in the chart above).
Compare the chart below, which illustrates the annual federal deficit in the two countries as a percentage of GDP, to the chart above. Notice how when the red line, (Canadian government deficit) moves aboe the blue line (US government deficit), the average spread drops (Section III in first chart)? That premium is now feeding into the 30-yr spread at an increasing rate (Section II of first chart).
I am in no way suggesting that the US should undergo a similar fiscal austertiy program as that taken in Canada in 1995 (please see Stephen Gordon at Worthwhile Canadian Initiative). What I am demonstrating, though – and rather qualitatively, I might add – is that absent active Fed purchases in the back end of the curve, there is a risk premium emerging in the US bond market relative to that of at least one country with markedly lower government deficits, all else equal, of course.