As the U.S. bond market suffers its worst rout since 2009, the gauge that historically signals more pain for fixed-income investors is instead suggesting yields (USGG10YR) are near their peak.
The gap between two- and 10-year Treasury yields widened to 2.55 percentage points this month, double the median of 1.23 points since 1990 and approaching the record 2.93 points in February 2010, data compiled by Bloomberg show. The yield curve is steepening at the fastest pace since 2009 as the Federal Reserve signals its intent to keep the target interest rate for overnight loans between banks at about zero into 2015 while reducing the bond-buying economic stimulus that drove 10-year yields to the highest level in more than two years.
While the yield curve typically steepens when faster growth leads investors to demand more insulation from inflation, bond strategists say this time is different. After rising from this year’s low of 1.61 percent on May 1 to 2.93 percent last week, the increase in 10-year yields will slow, with rates reaching 3.05 percent in the second quarter of next year, according to 63 economists in a Bloomberg News survey. Losses will be limited by an economy growing at half the post-World War II average and an inflation rate below the Fed’s 2 percent target, they say.
“I don’t think the steepness of the curve is reflective of very bullish expectations for growth or great concern for inflation,” Wan-Chong Kung, who helps oversee more than $100 billion as a fund manager at Nuveen Asset Management in Minneapolis, said in an Aug. 21 telephone interview. “It’s an artifact of the very accommodative monetary policy we continue to operate under.”
When the yield curve reached its record in February 2010, investors pushed the 10-year rate to 3.77 percent after the Fed restated its intention to withdrawal extraordinary stimulus measures as the economy strengthened.
The widest gap before the 2007 financial crisis was 2.86 percent in August 2003 as the Fed held its overnight rate at a then-record 1 percent while the economy lost jobs amid sluggish growth. The average spread in the 1980s was 0.48 percentage point, 0.88 percentage point in the 1990s and 1.06 percentage points from 2000 through 2008.
Yields on 10-year Treasuries reached 2.93 percent on Aug. 22, the highest since July 2011 as minutes of the Fed’s last meeting showed policy makers supported slowing the pace of its bond purchases this year. The price of the benchmark 2.5 percent note due August 2023 rose 3/32, or 94 cents per $1,000 face value, to 97 9/32 last week, Bloomberg Bond Trader prices show.
While yields touched the high for the year, bonds ended the week with a rally after a Commerce Department report showed that sales of newly built homes declined 13.4 percent in July to a 394,000 annualized pace, the weakest since October.
The yield was 2.80 percent today as of 12:26 p.m. in New York.
This year’s losses on Treasuries -- the Bloomberg U.S. Treasury Bond Index (BUSY) is down 3.6 percent -- will reverse by mid-2014 if the analyst survey proves correct. An investor buying $10 million of 10-year notes will earn about $160,000 after accounting for interest payments by June 30 even if yields rise to 3 percent.
Fed Chairman Ben S. Bernanke has said the central bank will keep its overnight lending rate at zero to 0.25 percent into 2015. That’s anchoring two-year note yields, which in turn restrain 10-year securities.
“Until such time as it’s pretty clear that the Fed is actually going to raise interest rates, an additional sell-off” will likely be capped, Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York, said in an Aug. 19 telephone interview. The firm is one of the 21 primary dealers of U.S. government securities that trade with the Fed.
Speculation that the Fed will taper its $85 billion of monthly bond purchases led to the rout in bond markets, with Treasuries losing 3.6 percent this year.
The decline is the worst since the 3.72 percent loss in all of 2009 and more than the 3.35 percent drop in 1994 after the Fed doubled its benchmark rate to 6 percent, according to the Bank of America Merrill Lynch U.S. Treasury index. The firm’s Global Broad Market Index has fallen 1.62 percent this year, the largest decline in data going back to 1997.
U.S.-registered bond mutual and exchange-traded funds lost $30.3 billion to investor redemptions this month through Aug. 19, the third-highest on record, according to a report last week by TrimTabs Investment Research in Sausalito, California. The withdrawals followed $69.1 billion of redemptions in June and $42 billion in October 2008.
“We are seeing retail bail out of bond funds,” Andrew Richman, the West Palm Beach, Florida-based director of fixed-income at SunTrust Bank’s private wealth management division, which oversees about $101 billion, said in an Aug. 21 telephone interview. “The Fed is going to slow down their bond purchases. Foreign investors are also slowing down their bond purchases. And banks are actually dumping some Treasuries and making more loans. All of that is really putting pressure on yields.”
Bank holdings of Treasury and agency debt fell $34.7 billion to $1.81 trillion in July, the biggest monthly drop in 10 years, and an additional $20 billion in the first week of August, Fed data showed on Aug. 16. Commercial and industrial loans at U.S. banks have surged to $1.57 trillion, the highest since 2008, from $1.49 trillion in December, Fed data show.
U.S. government securities held by international investors fell 2.2 percent to $5.6 trillion in June, and is down from the peak of $5.72 trillion in March, Treasury data show.
Traders are also selling Treasuries to hedge stakes in corporate and mortgage debt, John Briggs, a U.S. government bond strategist at RBS Securities Inc. in Stamford, Connecticut, said in an Aug. 20 telephone interview. RBS is also a primary dealer.
Fed policy makers were “broadly comfortable” with Bernanke’s plan to start reducing bond buying, known as quantitative easing, this year if the economy improves, with a few saying tapering might be needed soon, according to the record of the Federal Open Market Committee’s July 30-31 gathering released Aug. 21.
Reductions will be announced at the next FOMC meeting Sept. 17-18, according to 65 percent of economists in a Bloomberg survey conducted Aug. 9-13. Last month, 50 percent of respondents predicted a September reduction.
Investors see a 51.5 percent chance the Fed will raise borrowing costs by its December 2014 meeting, from about 40 percent a month ago, according to data compiled by Bloomberg.
Yields have also been increasing amid speculation about who will follow Bernanke when his term expires in January.
Lawrence Summers, the former Treasury Secretary under President Bill Clinton and National Economic Council director for President Barack Obama, current Fed Vice Chairman Janet Yellen and former Fed Vice Chairman Donald Kohn have been mentioned by the president as candidates.
A Bloomberg survey of 63 economists published Aug. 14 found that 65 percent said Yellen would be Obama’s pick and 25 percent expect the president to choose Summers.
“Because Yellen is viewed as another Bernanke, you have more certainty about the promises the Fed is making when it comes to low rates,” Briggs of RBS said. “With Summers there’s been a lot of effort to say that he’s pro-QE and he’s not going to be pulling back, but there’s extra uncertainty.”
The rise in yields has brought Treasuries closer to fair value, according to the term premium, which reached 0.55 percent Aug. 22, the highest since July 2011.
The gauge turned positive June 19 for the first time since October 2011, according to Columbia Management. A value of 0.50 percent to 0.75 percent is normal for a developed market economy with slow inflation, according to Zach Pandl, a money manager at the company, which oversees $340 billion.
Models of term premium, a gauge of the compensation investors demand for the risk of holding longer-duration debt, includes variables such as expectations for growth and inflation. The Fed’s purchases of debt through its quantitative easing programs first began in 2008 has helped depress long-term rates in part by damping the premium.
Economists have used the gap between yields on three-month Treasury bills and 10-year notes to predict economic contractions. Short-term rates have topped longer maturities eight times since 1960, with recessions following in seven of those cases. There hasn’t been a downturn that wasn’t preceded by a so-called inverted curve in that period.
As the curve has widened, consumer prices have remained tame and growth sluggish.
The personal consumption expenditures deflator, the Fed’s preferred measure of inflation, rose 1.3 percent in June, and has been below the central bank’s 2 percent target since May 2012. The five-year, five-year forward break-even rate, which projects the pace of consumer price increases starting in 2018, ended last week at 2.71 percent, below its average over the past decade of 2.75 percent.
The economy grew at a 1.7 percent annualized pace from April through June up from 1.1 percent for the first three months of 2013, Commerce Department data show. U.S. gross domestic product has grown an average of 3.3 percent a year since the end of World War II. It will expand 1.6 percent this year and 2.7 percent in 2014, according to the median estimate of about 70 economists in a Bloomberg survey.
The yield curve widening “has nothing to do with the economy, it just has to do with tapering and the idea that the biggest buyer in the market is going to ease back its purchases,” Richard Gilhooly, an interest-rate strategist at TD Securities Inc. in New York, said in an Aug. 21 telephone interview. “The market has already priced for its termination.”
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