May 13, 2021


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‘Humiliating’ week in bond markets raises fears of paradigm shift

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For the leading bulls in US government bonds, it has been a tough week, after a slight drop in prices suddenly turned into a rush.

With expectations of rising inflation, Treasury bill prices had fallen for most of the month, pushing yields to their highest level since the coronavirus crisis hit markets a year ago. But on Thursday, a U.S. government debt auction pushed 10-year yields up to 1.61%, ending the day with a gain of 0.14 percentage points.

“We are eating a humble pie, after the bond market has served a lesson in humility,” said Steven Major, head of bond research at HSBC. “The likelihood of lower bond yields has plummeted due to a much larger-than-expected US fiscal stimulus and the development of a number of effective vaccines.”

Bonds remain strong in historical terms. But for the generally stable and stable US government debt market, this magnitude is rare. The incident rekindled memories of chaotic scenes in Treasuries just under a year ago, and left investors wondering if a lasting and destabilizing rise in yields was within reach.

“Are we at a paradigm shift? That’s what worries people, that history isn’t really a guide for us now, ”said Joyce Chang, president of global research at JPMorgan.

What just happened?

US sovereign bonds are considered the deepest and most liquid market in the world. But on Thursday, that market faltered. “It was huge,” Rabobank analysts wrote. “It was almost like a dam was breaking.”

The rally in yields gathered pace after what BMO Capital Markets strategists described as an “extraordinarily low” auction of $ 62 billion of seven-year T-bills. The bid-to-coverage ratio, which tracks the value of bids received versus the amount accepted, has fallen to an all-time high.

“Rather than grabbing the infamous falling knife, several major auction participants may simply have chosen to stay away this month,” they said.

Primary traders, the financial firms that back US bond sales, accounted for nearly 40% of auctions, the highest share in seven years, Jefferies data shows – a sign of lukewarm demand from investors. investors.

Greg Peters, senior fund manager at PGIM Fixed Income, drew parallels with the turmoil that rocked the treasury market in March – a time marked by extreme price swings and pockets of illiquidity that spilled over to d other corners of the financial system.

“This is how it all started in March 2020,” he said. “I am not saying that we suffer the same economic and general market shock as a foreclosure. . . [but the market] definitely breaks here.

Other government bond markets also felt the pain. In Australia – the likely beneficiary of China’s early and rapid economic rebound – 10-year yields rushed to nearly 2 percent, the highest in two years.

Are debt markets overreacting?

In 2013, global bond markets fell sharply after the US Federal Reserve hinted at its intention to start withdrawing stimulus after 2008, in a shock known as the “taper tantrum”. This time we have “a tantrum, with no cones,” Johanna Chua wrote to Citi.

Still, the theme is the same: Investors are starting to assess the possibility of the Fed pulling out of its emergency measures introduced to mitigate the effects of the pandemic. In theory, the central bank would only do this if the US economy started to recover. He has already pledged to avoid a rise in inflation above his target of 2%. And inflation is stuck well below this level, at 1.5 percent. But investors are testing the Fed.

Line graph of 10-year yield (%) showing global bond yields rising after falling during the Covid crisis

“The market is selling for the right reasons,” said Bob Miller, head of fundamental fixed income for the Americas at BlackRock. “I think what the market is sniffing is that there is a chance that QE will be reduced sooner.”

What technical aspects are at stake?

Treasury yields are crucial to mortgage rates. When they increase, homeowners are less likely to refinance their mortgage because they’ve already locked in a lower cost of borrowing. The Mortgage Bankers Association notes that mortgage refinancing fell 11 percent in the week of February 19 compared to the previous one.

This means that mortgage investors will likely have to wait longer to get their money back. Deferred payments increase the risk these investors face due to rising interest rates, which is known as duration. To guard against increasing duration, investors sell treasury bills that mature in the future, exacerbating the rise in yields.

Bar chart of 10-year U.S. Treasury bill yields in previous fixed income sales (%) showing how the 2021 bond decline compares to previous episodes

The number of “convexity hedge” investors has declined over time. But they can still make a difference in times of high volatility, and analysts say they have this week.

Should investors in other asset classes be worried?

Even before Thursday’s shake-out, investors trying to calculate as the surge in yields would pose a threat to credit and equities.

Stock markets are flying high in large part because interest rates have been so low. If bond investors are correct that growth and inflation are strong enough to suggest lighter monetary support, then stocks, especially in high growth sectors like tech, are likely to be vulnerable. The recovery in yields has already left a bump in emerging market assets and currencies.

What, if anything, will central banks do?

Krishna Guha, vice chairman of Evercore ISI, said Fed management had some “responsibility” for the “messy” movement in inflation-adjusted Treasury bond yields this week. The 10-year real yield, which also serves as a barometer of expectations for future Fed rate moves, rose sharply to 0.6%, a far cry from all-time lows of more than less than 1. % and revert to levels last seen in June.

“The absence of any indication of concern or [central banker] caution around the movement of yields. . . was read in the markets as a green light to increase real returns, ”Guha said. “A change of tone at least seems justified in our opinion – and maybe more.”

This “plus” could lead to adjustments to the Fed’s $ 120 billion per month asset purchase program.

Some investors are also starting to speculate that the Fed may return to control of the yield curve – a policy it last used during World War II – with specific targets for bond yields, and buy and sell as many securities as needed to maintain those levels.

Fed officials are to divide on the benefits of penetrating even deeper into the fabric of financial markets, but according to Nick Maroutsos, head of global bonds at Janus Henderson, it’s one of many tools that may soon return to the limelight.

“They’re probably trying to pick their seats and wondering when they’re potentially going to step in,” he said.

Elsewhere, European Central Bank President Christine Lagarde and Chief Economist Philip Lane have made it clear that they are watch the yields closely.

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