Bernanke Boom Signaled by Yield Surge as Market Recalculates
The worst first half for Treasuries in four years has wrung the unprecedented Federal Reserve stimulus out of bond prices as investors now look to low inflation and slow economic growth to contain yields.
While yields on 10-year Treasuries rose to 2.58 percent last week from as low 1.61 percent in May, the term premium, which measures the risk of holding longer dated bonds by incorporating investors’ outlook for inflation and growth, suggests they are no longer overvalued.
“We actually just bought Treasuries because we think we are pretty close to that equilibrium price,” Jack McIntyre, a money manager who oversees $44.5 billion at Brandywine Global Investment Management LLC in Philadelphia, said in a July 9 telephone interview.
The term premium reached 0.46 percent this month, compared with the 0.40 percent average in the decade before the 2007 financial crisis and the Fed’s efforts to pump cash into the economy by purchasing bonds, according to Columbia Management Investment Advisers LLC. As recently as May, the measure was at minus 0.5 percent.
Bond bulls say the highest inflation-adjusted yields since March 2011, the slowest pace of increases in consumer prices since 2009 and below-average economic growth will support debt markets. The head of BlackRock Inc. (BLK), which manages about $4 trillion, and other bears say signals by the Fed that it could begin trimming the $85 billion it spends every month buying bonds this year, coupled with the fastest job gains since 2005 and stock indexes at record levels will diminish demand for fixed-income assets.
“If you look at inflation, the kryptonite for bond guys, we just don’t see it,” Brandywine Global’s McIntyre said. “We’ve gone through an adjustment where yields have gone higher. I don’t think yields will go significantly higher to entice” investors, he said.
The personal consumption expenditure deflator, the Fed’s preferred gauge of inflation, rose 1 percent in May from a year earlier, compared with a 0.7 percent rise in April that was the smallest since 2009.
Bond yields have advanced from 2.19 percent on June 18, the day before Fed Chairman Ben S. Bernanke said the central bank may start dialing down its unprecedented bond-buying program this year and end it entirely in mid-2014 if the economy finally achieves the sustainable growth the central bank has sought since the recession ended in 2009.
The increase in yields contributed to a 2.48 percent loss in Treasuries for the first half of the year, the most since 2009, according to Bank of America Merrill Lynch index (SPX) data. At the same time, the Standard & Poor’s 500 Index of U.S. stocks has risen 6.8 percent, erasing a 5.8 percent plunge from May 21 through June 24 that was based on speculation that any withdrawal of stimulus by the Fed would hurt the economy.
Yields reached 2.75 percent on July 8, the highest since August 2011. They fell 16 basis points last week, or 0.16 percent, the biggest slide since the period ended June 1, 2012, as the benchmark 1.75 percent note due May 2023 rose 1 10/32, or $13.13 per $1,000 face amount, to 92 25/32.
Yields on 10-year securities fell three basis points, or 0.03 percentage point, to 2.55 percent at 10 a.m. New York time.
Real yields, after subtracting the annual inflation rate, are 1.56 percentage points, about the most since March 2011. As recently as November, real yields were negative.
Term premiums show “there’s really not a valuation case against Treasuries,” Zach Pandl, a strategist and money manager at Columbia Management, which oversees $340 billion, said in a July 10 telephone interview.
In a developed market economy with slow inflation, a term premium of 50 to 75 basis points is normal and “at 40 basis points you’re approaching fair value,” said Pandl, who has developed models for the gauge. The rise in the measure after Bernanke’s comments shows Fed policy was “the single most important factor” in pushing the gauge below zero, Pandl said.
The term premium turned positive June 19 for the first time since October 2011, according to Columbia Management. A negative number showed that investors were willing to own bonds at such expensive levels as long as the Fed was buying. A positive one signals they are now demanding more in yield as the central bank steps back and the market reacts more to the economic outlook.
Economists and strategists see little change in yields for the remainder of 2013, ending the year at 2.62 percent, based on the median of 67 estimates in a Bloomberg survey. That’s below the average yield of 5.37 percent over the past 25 years.
“It’s going to be hard to sell-off unless something dramatically changes, which we don’t forecast over the next couple of months,” Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York, one of 21 primary dealers that trade with the Fed, said in a July 10 telephone interview.
Treasury 10-year note yields have probably established a new range between 2.40 percent and 2.75 percent, Jersey said.
Bond bears say an improving economy will allow the Fed to reduce bond buying this year and end it next year.
“Rates are going to go higher,” BlackRock Chief Executive OfficerLaurence D. Fink said in a July 10 interview on Bloomberg Television. “How far, how fast will be dependent on economic information.”
Payrolls rose by 195,000 workers for a second month in July, the Labor Department said July 5, topping the 165,000 gain projected by economists in a Bloomberg survey. The Conference Board’s index of consumer confidence rose to 81.4 in June, the highest since January 2008. Home prices have risen 12 percent since April 2012, the S&P/Case-Shiller Composite index shows.
Even with last week’s drop, yields will likely end the year at about 3 percent, according to Mitchell Stapley, the Grand Rapids, Michigan-based chief fixed-income officer for Fifth Third Asset Management, which oversees $15 billion.
“This is a market catching its breath,” Stapley said in a July 9 telephone interview.
Instead of Treasuries, Stapley said he’s buying commercial mortgage-backed debt, Treasury Inflation-Protected Securities and speculative-grade corporate bonds.
For all the gains in jobs, the International Monetary Fund last week cut its forecast for U.S. growth to 1.7 percent from a prior estimate of 1.9 percent in April.
That means a rise in borrowing costs brought on by the jump in Treasury yields may weigh on consumers. The average rate for a 30-year mortgage jumped to 4.51 percent as of July 11, the highest since July 28, 2012, from 3.40 percent on April 25, according to Freddie Mac.
“You have rising rates and slowing growth with no inflation,” said David Brownlee, the head of fixed income in Montpelier, Vermont at Sentinel Asset Management, which manages $28 billion in assets. “Before too long the bond market’s going to focus in on the D-word: deflation.”
In suggesting it could pare its bond purchases, “the Fed made a colossal blunder,” Brownlee said in a July 11 phone interview. Brownlee said he recently bought mortgage securities and Treasuries.
The expected rate of inflation in five years fell to 2.33 percent on June 20, which was the lowest level since before the Fed began its third round of asset purchases in September 2012. That’s based on the five-year five-year break-even rate, a gauge used by the central bank to gauge inflation expectations.
Treasury volatility suggests yields are unlikely to return to the lows seen last year anytime soon. The Bank of America Merrill Lynch MOVE index rose to 117.89 this month from as low as 48.87 in May before ending last week at 94.46. Higher readings suggest greater potential for price swings.
“The market had to recalibrate its thinking,” Kevin Flanagan, the Purchase, New York-based chief fixed-income strategist at Morgan Stanley Wealth Management, which oversees $1.8 trillion, said in a July 10 telephone interview.
“Part of the problem was there was this complacency, this QE-infinity notion, and everyone was on one side of that trade,” Flanagan said. “That had to be reversed and often times history tends to show you that you get these overreactions. Then the dust settles, you find your equilibrium level, and then you move on.”
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