Bond market Tumult puts ‘Longer lower’ in its sights

A series of Federal Reserve officials have said the climb is healthy and reflects investors’ improved expectations for a vaccine and stimulus-driven economic recovery. Many portfolio managers say they think interest rates are likely to level off in the coming days as yields finally reach what they think is attractive. Those views will be tested again this week, with Fed Chairman Jerome Powell scheduled to appear in public Thursday and the February jobs report released on Friday.

But there are signs, such as unusually weak demand for recent treasury auctions, that the sale may not be over and interest rates should rise further. Some traders are warning that bond markets are signaling a vigorous economic recovery that could boost the momentum that has kept borrowing costs low while pushing stocks to record highs – possibly a recipe for more of the past week’s volatile trading, when swinging more than 1,000 points over three days.

“There is an opinion that recovering from a pandemic looks different from a normal recession,” said Michael de Pass, global head of US Treasury Trading at Citadel Securities.

Traders said the momentum was evident at a Treasury auction late last week. Demand for five- and seven-year Treasury bills was weak on Thursday heading for a $ 62 billion seven-year banknote auction and nearly disappeared in minutes after the auction, one of the worst received analysts could recall.

The seven-year note sold at a yield of 1.195%, or 0.043 percentage points higher than merchants expected – a record gap for a seven-year note auction, according to analysts at Jefferies LLC. Primary dealers, large financial firms that can deal directly with the Fed and have to bid at auctions, were left with about 40% of the new notes, about twice the recent average.

Lukewarm demand worried investors as the government is expected to sell a massive amount of debt in the coming months to pay off the stimulus efforts underlying the recovery. Further poor auction results could fuel additional sales in bond markets and undermine the tone in other markets, such as those for stocks, investors say.

Analysts thought a greater supply of Treasurys could weigh the market into the year, but “it’s very different when you’re dealing with it,” said Blake Gwinn, head of US interest rate strategy at NatWest Markets.

Some traders said the recent moves have been exacerbated by the unwinding of popular trades where short-term treasuries are bought and other assets are sold against them. Many cited one in particular: the efforts of holders to protect their mortgage bond investments from the rise in interest rates, a practice known in the industry as convexity hedging.

The Fed’s rate cuts in the past year have sparked a wave of home sales and refinancing, but the recent rise in interest rates has pushed mortgage rates to their highest levels since last week’s November and filings have fallen. That forces banks and other holders, such as real estate mutual funds, to sell Treasurys to offset losses in mortgage bonds that occur when consumers stop refinancing.

Movements in market-based inflation indicators are also a cause for concern. Rising prices erode the purchasing power of fixed bond payments and could force the Fed to raise interest rates earlier than expected. While inflation has remained subdued for years, mostly below the Fed’s 2% target, some are concerned that the Fed’s and Congress’s economic reopening and stimulus efforts could accelerate.

The five-year break-even rate – a measure of expected annual inflation for the next five years, derived from the difference between five-year Treasury yields and the equivalent inflation-protected Treasury bill – reached 2.4% in recent days, the highest since May 2011.

“The question is whether inflation will be sustained at 2% once we reach it,” said Matthew Hornbach, Morgan Stanley’s chief macro strategy.

He said the magnitude of the US fiscal stimulus means that inflation “has a very reasonable chance of reaching 2% and staying there.”

At the same time, the recent rise in government bond yields not only reflected rising inflation expectations, as was essentially the case earlier this year. Over the past two weeks, returns on inflation-protected Treasury bills – a measure of so-called real returns – have also skyrocketed, with the 10-year TIPS yield rising from about minus 1% to minus 0.7%.

That move has caught the attention of investors as many credit are crediting very negative real returns by helping power stocks make records, leaving investors looking for riskier assets. Real yields were about zero percent or higher from mid-2013 to early 2020, meaning they may have more room to rise even after their recent move.

The yield on the 10-year US Treasury bill was 1.459% Friday, down from 1.513% a day earlier, but up 1.344% at the end of the week before.

For now, many investors are turning to assets that are less vulnerable to interest rate fluctuations. Stocks are less competitive with bonds when interest rates rise. Shares in some of the most popular technology stocks, including Amazon.com and Apple

have fallen from their peak in the past month.

Rick Rieder, Chief Investment Officer Global Fixed Income at BlackRock Inc., said his team bought floating-rate loans instead of bonds to protect against rising interest rates and capitalize on the economic recovery.

“We have converted much of our exposure to high yield bonds into loans,” said Mr. Rieder. “The real interest is negative 1%. They are finally on the move, but they have some more to go, which will eventually push interest rates higher than current levels. “

Write to Julia-Ambra Verlaine at [email protected] and Sam Goldfarb at [email protected]