Bond market tumult puts ‘lower for longer’ in crosshairs

A series of Federal Reserve officials said the rise was healthy, reflecting improving investor expectations for an economic recovery fueled by vaccines and stimulus measures. Many portfolio managers say they believe rates are likely to stabilize in the coming days, with yields finally reaching what they see as attractive levels. Those views will be retested this week, with Fed Chairman Jerome Powell making a public appearance on Thursday and the February jobs report released on Friday.

But there are signs, like unusually weak demand for the recent Treasury debt auctions, that sales may not be over and yields need to rise further. Some traders warn bond markets are signaling a strong economic recovery that could upend momentum that has kept borrowing costs low while propelling stocks to record highs – potentially a recipe for more upside trading seen over the past week, when industrialists swung over 1,000 points over three days.

“There is a view that a resumption of a pandemic looks different from a normal recession,” said Michael de Pass, global head of US Treasury operations at Citadel Securities.

Traders said the worrying momentum was evident at a Treasury auction late last week. Demand for five- and seven-year Treasuries was weak on Thursday, ahead of a $ 62 billion auction of seven-year notes and nearly evaporated within minutes of the auction, which was the one of the most badly received that analysts remember.

The seven-year note sold for a return of 1.195%, 0.043 percentage point higher than what traders had expected – a record spread for a seven-year note auction, analysts at Jefferies LLC said. . Primary traders, the large financial firms that can negotiate directly with the Fed and have to bid on auctions, ended up with about 40% of new notes, about double the recent average.

Lukewarm demand has worried investors as the government is expected to sell off a huge amount of debt in the coming months to pay for the stimulus efforts underpinning the recovery. Other poor auction results could fuel additional sales in bond markets and undermine other markets, such as stocks, investors said.

Analysts thought that an increase in the supply of Treasuries could weigh on the market early in the year, but “it’s a lot different when you face it,” said Blake Gwinn, head of government strategy. US rates at NatWest Markets.

Some traders said the recent moves have been exacerbated by the unfolding of popular trades that involve buying short-term Treasuries and selling other assets against them. Many pointed to one in particular: the effort by holders to protect their mortgage bond investments against rising yields, a practice known in industry jargon as convexity hedging.

Fed rate cuts over the past year have helped fuel a wave of home sales and refinances, but the recent rise in yields has pushed mortgage rates to their highest level since November last week , and demands have plummeted. This forces banks and other holders, like real estate investment trusts, to sell treasury bills to offset mortgage bond losses that arise when consumers stop refinancing.

Developments in market-based measures of inflation are also of concern. Rising prices reduce the purchasing power of fixed bond payments and could force the Fed to raise rates sooner than expected. While inflation has remained subdued for years, typically below the Fed’s 2% target, some fear the economic reopening and stimulus efforts by the Fed and Congress could spur an acceleration.

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

“The question is whether 2% inflation can be sustained once we hit it,” said Matthew Hornbach, global head of macroeconomic strategy at Morgan Stanley..

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

At the same time, the recent rally in Treasury yields has not only reflected rising inflation expectations, as was essentially the case earlier in the year. Over the past two weeks, the yields on inflation-protected Treasuries – a proxy for so-called real yields – have also climbed higher, with the 10-year TIPS yield falling from around minus 1% to minus 0.7%.

The move has caught the attention of investors, as many attribute deeply negative real returns to helping stocks reach record highs, pushing return-seeking investors into riskier assets. Actual returns were around zero percent or more between mid-2013 and early 2020, meaning they might have more leeway even after their recent move.

The benchmark 10-year US Treasury yield stood at 1.459% on Friday, down from 1.513% the previous day but up from 1.344% at the end of the previous week.

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

fell from their peaks last month.

Rick Rieder, director of global fixed income investments at BlackRock Inc., said his team was buying floating rate loans rather than bonds to hedge against rising interest rates and profit from the economic recovery.

“We have turned a lot of our exposure to high yield bonds into loans,” said Mr. Rieder. “Real rates are running at less than 1%. They are finally moving, but they still have a little more to do, which will eventually push interest rates higher than current levels. “

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