Citigroup blames Japanese banks for the flat yield curve. The BIS notes a conundrum. Neither explanation is correct.

A Citigroup analyst says don’t worry about the flat yield curve. Instead, Blame Japanese Banks.

“We believe that the latest leg of curve flattening has been, to a large extent, driven by front-end selling from Japanese banks and back-end buying from domestic pension funds, and we expect these flows to continue into next year,” said Citigroup strategists led by Jabaz Mathai in a note on December 1.

Under this theory, Japanese banks plowed into 5-year and under duration treasuries and are losing money because of rate hikes. Japan has now given up. Meanwhile, US pension funds, flush with profits are plowing into long duration treasuries.

The fact of the matter is pension plans have not recovered to healthy levels despite this rally.

BIS Conundrum

A BIS Quarterly Report makes this claim: Paradoxical Tightening Echoes Bond Market “Conundrum”.

An elusive tightening

Financial conditions have conspicuously eased in US markets over the last 12 months, despite the Federal Reserve’s gradual removal of monetary accommodation. After raising the federal funds rate target range for the first time in almost 10 years in December 2015, the FOMC has taken several further steps in that direction. Since last December, it has raised the target range another three times, amounting to 75 basis points. Finally in October, it started the process of trimming its $4.5 trillion balance sheet, in a move for which it had been preparing financial markets at least since its March meeting.

Yet investors essentially shrugged off these moves. Two-year US Treasury yields have indeed risen by more than 60 basis points since December 2016, but the yield on the 10-year Treasury note has traded sideways. Moreover, the S&P 500 has surged over 18% since last December, and corporate credit spreads have actually narrowed, in some cases significantly. Overall, the Chicago Fed’s National Financial Conditions Index (NFCI) trended down to a 24-year trough, in line with several other gauges of financial conditions.

In many respects, the current tightening cycle has so far been reminiscent of its mid-2000s counterpart. At the time, Federal Reserve Chair Alan Greenspan had characterized the fall in long-term yields as a “conundrum”.