Bond-Market Game of Chicken With Fed Is Riskier Than Ever

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Uncertainty in Bond, Stock Correlations: Rosenberg

If the Federal Reserve is really so intent on raising interest rates this year, why is Wall Street chopping its forecasts for bond yields?

For all the hand-wringing over the recent selloff that wiped out about $1.2 trillion in value from the global bond market, the fixed-income market’s best and brightest have actually taken down their year-end estimates for Treasuries in four of the past five months.

It amounts to a dangerous game of chicken, in which many analysts and investors are betting the Fed won’t lift rates too fast because of the damage it may inflict on the economy -- even after last week’s stronger-than-expected jobs report. And the stakes have never been higher for holders of debt globally, who are more exposed to the potential for big losses than at any time in history, based on a metric known as duration.

“When things have settled down, as they inevitably will, the U.S. will trade on fundamentals again,” said Chris Low, the chief economist at FTN Financial in New York.

Low, one of the few who correctly predicted last year’s rally in Treasuries, cut his year-end yield forecast for 10-year notes in April to 2.1 percent from 2.5 percent. They ended at 2.41 percent on Friday. The yield was 2.39 percent as of 12:44 p.m. in New York.

When it comes to Treasuries, Low has been among the most bullish on Wall Street, even as forecasters in a Bloomberg survey consistently reduced their yield estimates this year to a median of 2.5 percent from 3.01 percent in December.

The risk, of course, is that those projections get overrun as money managers start to question whether the more than three-decade bull market in bonds has finally run its course.

Global Consequences

That has real-world consequences for everyone from governments to businesses and consumers since Treasuries serve as the benchmark for borrowing costs on trillions of dollars of debt worldwide.

Bonds globally have tumbled in the past month, causing yields to soar from historical lows, as deflation worries ebbed in Europe and U.S. economic data pointed a resurgent labor market following a surprise first-quarter contraction.

Since April, yields on U.S. 10-year notes have surged a half-percentage point. The selloff accelerated last week after a report showed wages in May rose by the most since August 2013 as hiring surged, strengthening the Fed’s case for higher rates.

Fed Chair Janet Yellen, who said in May that she expects to raise borrowing costs this year if the economy meets her forecasts, also warned yields may soar once that happens.

‘Tough Go’

The data “really confirms what Janet Yellen’s been signaling,” said Christopher Sullivan, who manages $2.4 billion as chief investment officer at United Nations Federal Credit Union. “Bonds could be in for a further tough go from here.”

After all, the potential for losses is now greater than at any time on record, based on duration levels for $50 trillion of debt tracked by Barclays Plc. If yields on 10-year Treasuries rose to 3 percent by year-end, investors today would face losses of 3.6 percent, data compiled by Bloomberg show.

While there’s little doubt the U.S. economy is the world’s bright spot, growth is still far from booming. And there’s lingering concern the recent slowdown was more than just the result of some bad weather.

That suggests there’s room for Fed officials to remain patient when it comes to how soon, and perhaps more crucially, and how much they need to increase borrowing costs, according to Peter Yi, the director of short-term fixed income at Northern Trust Corp., which oversees $960 billion.

Diminished Expectations

Even as the labor market showed signs of improvement, household spending and retail sales have fallen short of economists’ estimates every month in 2015.

If the Fed does decide to raise rates before January, it would be doing so when U.S. corporate earnings are forecast to grow less than at the start of any tightening cycle since 1980.

“Unless you start hitting on all cylinders, it’s really difficult to see the Fed raise rates more than the market is expecting today,” said Yi.

Traders in the futures market are still largely divided on a September rate boost even after last week’s jobs report, and most expect the Fed will hold off until December.

Regardless of when exactly the first increase comes, the market doesn’t foresee rates exceeding 1.25 percent before the end of 2016, versus the Fed’s own estimate of 1.875 percent.

For many bond investors, those diminished rate expectations reflect just how little inflation the economy has been able to generate over the course of the expansion.

Flip-Flop

Using the Fed’s preferred measure, inflation reached just 0.1 percent in April from a year ago -- the 36th straight month the gauge has fallen short of the central bank’s 2 percent goal.

It’s this lack of price pressure that has prompted so many investors to pour into longer-term debt to generate higher real returns as yields hover close to their historical lows -- a decision that’s roiled the market as bonds tumbled.

Cathy Roy, the chief investment officer for fixed-income at Calvert Investments, which oversees $13 billion, is convinced the most recent bond-market hiccup is just that.

Put into context, the 0.38 percentage point jump in 10-year yields since the end of April still pales in comparison to the surge during the start of the “taper tantrum” in 2013, while absolute levels are well below last year’s peak.

And just this February, yields actually jumped about twice as much before falling back again.

“Every day you come in and there’s been a complete flip-flop on the consensus view on where interest rates are going,” Roy said. “We’re staying the course with our long-term outlook of lower rates for longer and then trying to take advantage of this volatility.”

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