Bond-Market Tumult puts ‘Lower for longer’ in the crosshairs

A series of Federal Reserve officials said the climb is healthy, reflecting investors’ expectations for an economic recovery fueled by vaccine and stimulus. Many portfolio managers believe that rates are likely to flatten in the coming days as the returns eventually reach what they consider attractive levels. These views will be re-tested this week, with Jerome Powell, chairman of the Fed, making a public appearance on Thursday and the release of February’s work report on Friday.

But there are signs, such as an extraordinarily soft demand for recent Treasury debt auctions, that sales may not be over and that yields should rise further. Some traders warn that bond markets are signaling a strong economic recovery that could boost the dynamics that kept borrowing costs low while moving stocks to records – possibly a recipe for more trading seen last week when Dow Industries more than 1,000 points swung over three days.

“There is an opinion that the recovery from a pandemic looks different from a normal recession,” said Michael de Pass, global head of U.S. Treasury trading at Citadel Securities.

Traders said the dynamics appeared at an Treasury auction late last week. Demand for Treasurys for five and seven years was weak on Thursday at a $ 62 billion auction of seven-year notes and almost evaporated in the minutes after the auction, which was one of the worst receipts analysts could remember.

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

The low demand has affected investors as the government is expected to sell a large amount of debt in the coming months to pay for 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 equities.

Analysts thought a larger offering of Treasurys could weigh on the market over the course of the year, but ‘it’s very different if you really deal with it,’ says Blake Gwinn, head of NatWest Markets’ US pricing strategy.

Some traders have said that recent moves have been exacerbated by the withdrawal of popular trades that include buying short-term Treasury and selling other assets against it. Many have singled out one in particular: the attempt by holders to protect their mortgage lending investments against rising yields, known in the vernacular as convexity hedging.

The Fed’s interest rate cuts over the past year have helped a wave of home sales and refinancing, but the recent rise in yields has pushed mortgage rates to the highest level since November last week, and applications have fallen. It forces banks and other holders, such as investment trusts in real estate, to sell Treasurys to offset losses in mortgage bonds that occur when consumers stop refinancing.

Movements in the market-based measures for inflation are also a cause for concern. Rising prices detract from the purchasing power of fixed payments from bonds and could force the Fed to raise rates sooner than expected. While inflation has been subdued for years, usually below the Fed’s target of 2%, some are concerned that economic reopening and stimulus efforts by the Fed and Congress could cause 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 returns on five-year treasury and the equivalent security protected by treasury inflation – has in recent days 2, 4%, the highest since May 2011.

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

He said the magnitude of the U.S. fiscal stimulus means that inflation has a very reasonable chance of getting to 2% and staying there. ‘

At the same time, the recent rise in treasury yields not only reflects rising inflation expectations, as was essentially the case earlier this year. Over the past two weeks, yields on the inflation-protected effects of the Treasury – a proxy for so-called real yields – have also skyrocketed, with the ten-year TIPS yield rising from around minus 1% to minus 0.7%.

The move has attracted investors’ attention as many creditworthy negative real returns have helped power outputs, driving return-seeking investors to riskier assets. Real returns were around zero percent or higher from mid-2013 to early 2020, meaning they will have more room to rise even after their recent move.

The yield on the standard 10-year U.S. Treasury note fell 1.459% on Friday, up from 1,513% a day earlier, but up from 1,344% at the end of the previous week.

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

has fallen from their highs in the past month.

Rick Rieder, chief investment officer of global fixed income at BlackRock Inc., said his team bought floating rate loans rather than bonds to protect against rising interest rates and benefit from the economic recovery.

“We have turned a large part of our exposure to high-yield loans into loans,” he said. Rieder said. ‘The real rate is 1% negative. They are finally moving, but they still have a little more to go on, which will eventually cause interest rates to rise higher than today’s levels. ”

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