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Taper Isn’t Tightening as Bonds See No Rate Boost Until ’15

U.S. Treasury Note Traders
Traders work in the ten-year U.S. Treasury Note options pit at the Chicago Board of Trade. Photographer: Daniel Acker/Bloomberg

The $11.7 trillion Treasury market is betting on history not repeating as the Federal Reserve moves closer to reducing its unprecedented stimulus.

From futures to derivatives, traders don’t see the central bank raising its benchmark interest rate from a record low until nine months after policy makers end their monthly bond purchases of $85 billion, or late 2015. In September, when the Treasury market was tumbling in the midst of its worst year since 2009, the projected gap was two months, according to Barclays Plc.

The Fed’s assertion that the tapering of its quantitative easing doesn’t mean a tightening of monetary policy is starting to sink in among bond traders. That may help contain yields, supporting borrowers of all types that have refinanced trillions of dollars of debt because of the Fed’s policies.

When Fed Chairman Ben S. Bernanke first discussed ending purchases May 22, “there was a consensus opinion that ‘Oh my God, this is the end,’” and that an increase to the federal funds rate would “be right on the heels of that last purchase,” said Gregory Whiteley, who manages government debt investments at Los Angeles-based DoubleLine Capital LP, which oversees $53 billion. “That is not the consensus any longer,” he said in a Nov. 19 telephone interview.

Treasuries have returned 0.62 percent since the start of September, after losing 3.95 percent the previous four months. Yields on 10-year notes -- a benchmark for everything from corporate bonds to mortgages -- have fallen to 2.74 percent from 3 percent on Sept. 6, which was the highest since July 2011.

‘Slowing Down’

The losses were sparked by Bernanke’s May comments that policy makers “could take a step down in our pace of purchases,” in the “next few meetings.”

“Tapering is not a tightening, rather it’s just a slowing down of the easing,” Joe Ramos, a bond fund manager in New York at Lazard Asset Management, which oversees $176 billion, said in a Nov. 20 phone interview. “Once the first tapering happens, and the market sees it is small, the 10-year yield will likely go back to what is a more normal level of around 3 percent.”

That’s a view shared by the manager of the world’s biggest bond fund. Yields will be capped at about 3 percent into 2015 even with the Fed beginning to trim asset purchases as soon as January, Tony Crescenzi, a money manager at Newport Beach, California-based Pacific Investment Management Co., said in an interview last week.

Fed Minutes

Yields on 10-year Treasuries rose four basis points last week, or 0.04 percentage point, to 2.75 percent, according to Bloomberg Bond Trader prices. The price of the benchmark 2.75 percent note due in November 2023 fell 11/32, or $3.44 per $1,000 face amount, to 100 1/32. The yield was 2.74 percent as of 2:27 p.m. in New York. Yields have averaged 2.66 percent since December 2008 and 3.51 percent the last decade.

Minutes of the Federal Open Market Committee meeting Oct. 29-30 released Nov. 20 showed that Fed officials expected to reduce their purchases “in coming months” as the economy improves. Assuming that tapering begins in March, as forecast by Barclays, the firm expects the central bank will slow purchases over the course of six months ending them in September.

Implied yields on federal funds futures traded at the CME Group exchange signaled on Sept. 5 that traders saw a 64 percent chance the Fed would begin lifting its target rate, which has ranged from zero to 0.25 percent since December 2008, in December 2014. That probability has tumbled to 8.8 percent.

Widening Expectations

Sentiment changed after the FOMC meeting Sept. 17-18, when the central bank surprised investors by not announcing a tapering of purchases. Before then, the market was pricing a two-month gap between the end of tapering and the first rate increase, compared with nine months now, according to Joe Abate, a money-market strategist at Barclays.

“It was if the market really didn’t internalize that until the September FOMC meeting,” Abate, whose London-based firm is one of the 21 primary dealers of U.S. government securities that trade with the Fed, said in a Nov. 19 phone interview.

Forward markets for overnight index swaps, which show what the federal funds effective rate will average over the life of the contract, suggest traders don’t expect the Fed to begin raising rate until the second half of 2015.

That’s the message the Fed has been trying to communicate. Janet Yellen, President Barack Obama’s nominee to succeed Bernanke, won’t remove stimulus too soon, even as the Fed’s bond buying comes to a close, she said Nov. 14 in Senate testimony.

Global Declines

“The message we want to send is that we will do what is in our power to assure a robust recovery in the context of price stability,” Yellen said.

That message was muddled after Bernanke’s May comments, sending 10-year note yields up from as low as 1.61 percent on May 1. The selloff in bonds rippled across the world, with companies slowing bond sales and emerging markets tumbling amid concern that there will be less cash floating around the financial system to invest in riskier assets.

Fed difficulties in May and June preparing the markets for a tapering suggest “it’s unlikely they can thread the needle with the exit of QE,” James Camp, a money manager who oversees $5.5 billion in fixed-income assets at Eagle Asset Management in St. Petersburg, Florida, said in a Nov. 20 phone interview.

“The markets generally expect tapering, the markets generally conclude that tapering will be disruptive to the yield curve and to risk assets,” Camp said. With few investors having made significant changes to their holdings in anticipation of the Fed’s reduction in purchases, many are gripped by “that, ‘yeah, we know it’s coming; we’ll get out in time’ idea that I don’t think is going to work,” he said.

Market Sentiment

Camp has cut holdings of mortgage securities and bought asset-backed bonds, and has focused on buying higher-rated credits and debt maturing in four- to seven-years, he said.

Two measures of market sentiment show the link is fraying between concern the Fed will end its bond purchases and expectations for rate increases.

The term premium on 10-year debt, which shows the extra yield investors demand for the risk of holding longer-duration bonds given the outlook for items such as growth and inflation, has risen to 0.26 from a four-month low of 0.13 on Oct. 29, according to a Columbia Management model. The current reading is above the average of 0.21 over the last decade and shows investors see bonds as close to fairly valued.

Markets are doing a better job “differentiating” between the Fed’s plans to hold interest rates low even after it begins to slow bond purchases, Bernanke said in response to audience questions after a Nov. 19 in speech to economists in Washington.

Corporate Borrowing

That bodes well for the government, which faces the prospect of refinancing a record $1.4 trillion of notes and bonds next year. Borrowers have raised $1.5 trillion this year in the U.S. corporate bond market through Nov. 22, according to data compiled by Bloomberg. That marks a record pace even though sales slowed in the third quarter.

“We hope they have learned a lot from the summer episodes” of rising yields, Krishna Memani, the New York-based chief investment officer of OppenheimerFunds Inc.’s $79.1 billion fixed-income portfolio, said in a Nov. 19 phone interview. “It’s a good thing for the Treasury market, it’s a good thing for the corporate credit sector.”

OppenheimerFunds holds a greater percentage of corporate and municipal bonds than is contained in benchmark indexes, a sign that he is bullish on those securities.

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