Treasury Bears Give Up as Low Yields Seen Through Election
Less than three months after rising yields foretold a bear market in Treasuries, bond market metrics show growing investor confidence that record-low borrowing costs will last for years.
As yields on 10-year notes tumbled, dropping below 1.5 percent last week for the first time, investors who had sought protection from bond losses retreated, reducing the so-called payer skew in options on interest-rate swaps from a near one-year high. Money-market traders drove the yield on futures contracts that expire at the end of 2014 to record lows.
While Treasuries lost 1.3 percent in the first quarter as bond prices fell and 10-year yields rose to 2.4 percent, they have since returned 3.9 percent, Bank of America Merrill Lynch indexes show. Rising concern that Greece will exit the euro, increasing unemployment in the U.S. and Europe and slowing Chinese manufacturing growth drove investors to the safety of U.S. debt, cutting borrowing costs for homeowners, companies and the government ahead of the November presidential election.
“When all bets are off there is a race to the most liquid and safest assets,” Michael Brandes, global head of fixed-income strategy for Citi Private Bank, a unit of Citigroup Inc., with $250 billion in assets under management, said in a May 31 interview. “We are more likely to see the 10-year yield stay around these levels, or decline further, than to go back to 2 percent anytime soon unless we get a positive surprise.”
Strategists at New York-based JPMorgan Chase & Co., which in early April forecast 10-year yields would rise to 2.5 percent, said in a report dated June 1 that it lowered its estimate to 1.4 percent. Goldman Sachs Group Inc. and Credit Suisse Group AG also cut their estimates.
Morgan Stanley, who along with JPMorgan, Goldman Sachs and Credit Suisse, are among the 21 primary dealers of U.S. government securities that trade with the Federal Reserve, said June 1 that the probability of the central bank adding more stimulus when its current effort winds down this month is 80 percent, up from 50 percent.
“Rates are going to remain low for quite a long time period and if anything for longer than what people expect,” said James Sarni, senior managing partner at Los Angeles-based Payden & Rygel, which manages over $70 billion. “That’s simply because of the continued problems in Europe as well as our own economic and political uncertainties and challenges. There’s been a change of sentiment since the end of the first quarter and not for an unjustified reason.”
Yields on 10-year Treasuries ended last week at 1.45 percent, as the Labor Department reported job gains of 69,000 in May, the fewest in a year, and said the unemployment rate rose to 8.2 percent from 8.1 percent in April. Commerce Department figures a day earlier showed the economy expanded at a 1.9 percent annual rate last quarter, below its 2.2 percent prior estimate.
In Europe, a gauge of manufacturing output for the 17-nation euro area contracted for a 10th month in May, as the London-based Markit Economics’ purchasing managers’ index declined to 45.1 from 45.9 in April. Manufacturing in China grew last month at the slowest pace this year, trailing 26 of 27 estimates in a Bloomberg survey, according to an index published by the nation’s statistics bureau and logistics federation.
The benchmark 10-year Treasury yield fell 29 basis points last week, or 0.29 percentage point, the most in eight months, according to Bloomberg Bond Trader prices. The 1.75 percent security maturing in May 2022 gained 2 20/32, or $26.25 per $1,000 face amount, to 102 3/4.
The yield rose to 1.50 percent as of 3 p.m. in New York. It reached an all-time low of 1.4387 percent during trading on June 1.
By some measures, the turnaround means that Treasuries are overvalued. The term premium, a model created by economists at the Fed, fell to negative 0.94 on June 1, the lowest level ever. A negative reading indicates investors are willing to accept yields below what’s considered fair value.
A Bloomberg survey of 69 economists and strategists shows 10-year yields are expected to rise to 2.41 percent by year-end.
Bonds also reflect growing speculation that Greece will exit the 17-nation euro region after parties opposed to the terms of the nation’s second bailout by the European Union and the International Monetary Fund won most of the votes in May 6 elections. Greece’s departure would spark uncontrollable contagion that may exhaust official funding sources, according to Societe Generale SA analysts.
A fresh round of voting will be held June 17 after leaders failed to form a government and a victory by Greek politicians who favor the strict bailout conditions may reduce economic concerns and draw investors out of Treasuries.
“You’ll probably see some measures taken out of Europe that will ease the concerns, not solve the problems but ease them, and then we could see Treasury yields rise back north of 2 percent,” Thomas Higgins, global macro strategist in Boston at Standish Mellon Asset Management Co., with $92 billion of fixed-income assets, said in an interview on May 30.
For now, signs of a waning U.S. economic recovery and turmoil in Europe are leading money market traders to cut bets that the Fed will lift benchmark rates before 2015.
The Federal funds futures contracts expiring in December 2014, traded on the Chicago-based CME Group exchange, fell 14 basis points last week to 0.37 percent.
The Fed lowered its benchmark interest rate to about zero in December 2008 and has said economic conditions will probably warrant holding it low through at least late 2014. Policy makers next meet June 20 to decide monetary policy.
Federal Reserve Bank of Boston President Eric Rosengren said June 1 before the jobs report that central bank should spur growth and cut unemployment by prolonging a program that lengthens the average duration of bonds on its balance sheet by selling $400 billion of short-term debt and buying longer-term in a policy traders have dubbed Operation Twist.
“That would have the impact of helping to reduce longer-term interest rates without expanding our balance sheet,” Rosengren said in an interview with Bloomberg News. “If you were looking for something that would promote growth but didn’t have an impact on our balance sheet, then certainly extending the maturity extension program would be a viable way forward.”
Options traders are reversing course. Last year they wagered that the only way prices swings would increase was if yields rose. That changed last month as measures of projected interest-rate volatility in options on swaps trended higher as yields fell.
“Everybody had been using options over the last six months to position for higher rates with almost nobody buying them to hedge lower rates,” said Piyush Goyal, a fixed-income strategist in New York at Barclays Plc, in a telephone interview on May 29. “All of that has changed.”
The option market’s thirst for insurance against even lower Treasury yields comes as higher-risk securities, such as equities, have slid. The Standard & Poor’s 500 Index had its worst month since September in May, retreating 6.3 percent as the euro weakened to an almost two-year low against the dollar, reaching $1.2288 last week.
Costs to hedge against rising 10-year yields over the next three years, as measured by the payer skew in options on interest-rate swaps, began to retreat in mid-May after surging 50 percent since the end of March to an eight-month high, according to Barclays data.
The skew reached 21 basis points on May 23, up from 14 basis points at the end of the first quarter, and averaging 15 over the past 12 months, Barclays data show. It fell to 20 basis points on May 24, where it held for four straight days before rebounding as the 10-year Treasury yield set record lows the final three days of last week.
Lower 10-year Treasury yields may bring down home loan rates, already at record lows, further as the Fed completes Operation Twist. The average for a typical 30-year fixed-rate mortgage fell to 3.75 percent on May 24, from 4.08 percent on March 22 and more than 5 percent in February 2011, according to Freddie Mac surveys.
Investment-grade company bond yields tumbled to 3.33 percent May 8, the least in data going back to 1986, the Bank of America Merrill Lynch U.S. Corporate Master Index shows.
Low interest rates have allowed President Barack Obama’s administration to finance three years of budget deficits exceeding $1 trillion without igniting price increases.
While the amount of marketable Treasuries outstanding has more than doubled to $10.4 trillion from $4.4 trillion in mid-2007, debt expense equaled 3 percent of the economy in fiscal 2011 ended Sept. 30, less than the 4 percent in 1999, when the U.S. ran a budget surplus.
Tax increases and spending cuts of $450 billion will kick in at the end of this year unless Congress blocks them, potentially slowing the economy further. Mark Zandi, chief economist at Moody’s Analytics Inc. in West Chester, Pennsylvania, estimates full implementation would cut 1.5 percentage points from growth next year.
Fed policy makers signaled last month that further monetary easing remains an option to protect the U.S. economy from the danger that lawmakers will fail to reach agreement on the budget or Europe’s debt woes worsen, according to minutes of the Federal Open Market Committee’s April meeting released on May 16 in Washington.
“It’s tough to see exactly where the bottom might be” in Treasury yields, Gregory Whiteley, who manages investments in government debt at Los Angeles-based DoubleLine Capital LP, which has $35 billion in assets, said in a June 1 telephone interview. “All the stars are lined up for this drop in yields to continue. The likelihood of Fed action is going up here.”
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