Bond market turmoil put ‘lower for longer’ in the crosshairs

A number of Federal Reserve officials said the escalation is healthy, reflecting investors’ rising expectations for an economic recovery fueled by vaccines and stimuli. Many portfolio managers say they believe that rates are likely to stabilize in the coming days, as yields finally reach what they find attractive levels. These views will have a new test this week, with Fed Chairman Jerome Powell scheduled to make a public appearance on Thursday and the February jobs report to be released on Friday.

But there are signs, such as unusually low demand for the recent Treasury debt auctions, that the sale may not be over and yields may have to rise further. Some traders warn that bond markets are signaling a powerful economic recovery that could change the momentum that kept borrowing costs low, while boosting stocks to record highs – potentially a recipe for more backwards trading last week when the industrial Dow rocked over 1,000 points in three days.

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

Traders said the worrying momentum was evident at a Treasury auction last week. Demand for five- and seven-year Treasury bonds was weak on Thursday for an auction of $ 62 billion of seven-year notes and almost evaporated in the minutes after the auction, which was one of the worst received by analysts can remember.

The seven-year note was sold at 1.195%, or 0.043 percentage points more than traders expected – a record gap for a seven-year note auction, according to analysts at Jefferies LLC. Primary brokers, large financial companies that can trade directly with the Fed and are required to bid at auctions, have taken about 40% of the new notes, about twice the recent average.

The lukewarm demand has worried investors because the government is expected to sell a large amount of debt in the coming months to pay off the stimulus efforts that sustain the recovery. Other poor auction results could fuel additional sales in the bond markets and undermine the tone in other markets, such as equities, investors said.

Analysts thought an increase in the supply of Treasury bills could weigh on the market earlier this year, but “it’s very different when you’re really dealing with it,” said Blake Gwinn, head of US rate strategy at NatWest Markets.

Some traders say the recent moves have been exacerbated by the reversal of popular trades that involve buying short-term Treasury bills and selling other assets against them. Many highlighted one in particular: the holders’ effort to protect their investments in mortgage bonds 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 refinancing, but the recent spike in yields has brought mortgage rates to their highest level since November last week, and orders have fallen. This forces banks and other holders, such as real estate investment funds, to sell Treasury bills to make up for the losses in mortgage bonds that happen when consumers stop refinancing.

Movements in market-based inflation measures are also raising concerns. Rising prices undermine the purchasing power of fixed bond payments and may force the Fed to raise rates earlier than expected. Although inflation has remained low for years, generally below the Fed’s 2% target, some fear that the economic reopening and stimulus efforts by the Fed and Congress may trigger an acceleration.

The five-year equilibrium 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 bills – reached 2.4% in the past days, the highest since May 2011.

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

He said that the scale 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 increase in Treasury yields did not just reflect the increase in inflation expectations, as was essentially the case at the beginning of the year. In the past two weeks, yields on securities protected by Treasury inflation – a representation of so-called real yields – have also skyrocketed, with the 10-year TIPS yield rising from around 1% less to 0.7% less.

This move caught the attention of investors because many credit profoundly negative real yields by helping to keep stocks at record levels, pushing investors in search of yield to riskier assets. Actual yields were around zero percent or more from mid-2013 until the beginning of 2020, which means they may have more room to rise, even after their recent move.

Yield on the 10-year US Treasury benchmark note closed at 1.459% on Friday, down from 1.513% the previous day, but above 1.344% at the end of the previous week.

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

fell from their highs last month.

Rick Rieder, director of global fixed income investments at BlackRock Inc., said his team has been buying floating rate loans instead of bonds to protect against rising interest rates and benefit from the economic recovery.

“We have turned a large part of our exposure into high-yield securities on loans,” said Rieder. “Real rates have been running at a negative 1%. They are finally moving, but they still have a little more to do, which will eventually raise interest rates to current levels. “

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