Treasury 2-Year Notes Fall Most Since 2011 on Fed Outlook

Treasury two-year notes tumbled, pushing yields up the most since 2011, after Federal Reserve Chair Janet Yellen suggested policy makers may begin raising interest rates by the middle of next year.

Yields on all government securities surged as the Federal Open Market Committee dropped a linkage between the benchmark interest rate and a specific level of unemployment, saying its assessment takes into account a “wide range of information,” including labor-market conditions, inflation expectations and financial markets. Yellen indicated the Fed’s bond-buying program will wind down by year-end as forecast and a rate increase could follow in about six months. Treasury trading volume nearly doubled.

“The FOMC was more hawkish,” said Anthony Valeri, a market strategist with LPL Financial Corp. in San Diego, which oversees $350 billion. “The expectation for higher rates got pushed forward and the bond market was not priced for that.”

The two-year note yield rose seven basis points, or 0.07 percentage point, to 0.42 percent at 5 p.m. in New York, according to Bloomberg Bond Trader prices. It earlier climbed 10 basis points, the most since June 2011.

The benchmark 10-year note yield rose 10 basis points to 2.77 percent. The 2.75 percent note due in February 2024 dropped 7/8, or $8.75 per $1,000 face amount, to 99 26/32.

Yields on the notes declined 13 basis points last week, the most since the period ended Jan. 10, amid turmoil between Russia and Ukraine over control of Crimea.

Fed Funds

Treasury trading volume rose 97 percent to $559 billion, according to ICAP Plc, the largest inter-dealer broker of U.S. government debt. Volume rose to $582.4 billion on March 13, the highest in more than nine months, according to ICAP.

Fed officials predicted their target interest rate will be 1 percent at the end of 2015 and 2.25 percent a year later, higher than previously forecast, as they upgraded projections for gains in the labor market.

Forward markets for overnight index swaps, derivative contracts that speculate on the path of the federal funds rate, show traders predict the central bank will first raise rates in about June 2015, according to data compiled by Bloomberg. Before the ending of the Fed policy meeting the increase in rates was forecast a month later.

‘More Optimism’

“You have the Fed members increasing where they think the funds rate is going to be at the end of 2015 and the end of 2016 by 25 basis points, and that’s what the market focused on,” said Michael Materasso, senior portfolio manager and co-chairman of the fixed-income policy committee at Franklin Templeton Investments in New York. The firm oversees $320 billion of bonds. “There’s more optimism on the economy by the FOMC, and that’s reflected by those numbers.”

The FOMC held the benchmark interest rate, the target for overnight loans between banks, at zero to 0.25 percent, where it has been since December 2008.

Yellen, in a news conference, played down the importance of the forecasts.

“These dots are going to move up and down over time,” she said in a reference to the forecasts, which are illustrated as dots on a chart. They moved up “ever so slightly,” she added. “The committee’s views on policy will likely evolve.”

Rate Expectations

The Fed is overhauling forward guidance after unemployment declined toward 6.5 percent, its previous threshold for a rate increase, faster than policy makers predicted. Yellen last month told lawmakers that the unemployment rate alone isn’t an adequate gauge of economic health.

The central bank previously said it would maintain the rate at least as long as unemployment is above 6.5 percent and inflation projections are below 2.5 percent.

Slowing inflation has cut any urgency for the Fed to raise its target rate. The Fed’s preferred gauge of inflation, known as the personal consumption expenditures deflator, has been below the central bank’s 2 percent goal for 21 consecutive months and was at 1.2 percent in January from a year earlier.

“We are closer to the end of a stable-rate environment -- you have to adapt to the signal the change is coming,”said William Larkin, a money manager who oversees $520 million in assets at Cabot Money Management in Salem, Massachusetts. “Getting to 1 percent in 2015 is a real baby step.”

The Fed has undertaken three rounds of bond-buying since 2008 under the quantitative-easing stimulus strategy, swelling its balance sheet to a record $4.2 trillion to boost the economy.

Yield Curve

The difference between the yields on the two-year note and the 30-year bond, known as the yield curve, narrowed to 324 basis points, the least on a closing basis since Feb. 3. It earlier touched 322 basis points.

“Buyers are back in the long end,” said James Combias, New York-based head of Treasury trading at Mizuho Securities USA Inc., one of 22 primary dealers that trade Treasuries with the Fed. “Tighter policy is going to mean a flatter curve and more demand for the back end. The front end -- given where it’s priced and if the Fed moves sooner -- that clearly is more susceptible.”

The Bloomberg U.S. Treasury Bond Index has fallen 0.1 percent in the past month, paring its 2 percent return this year. The Standard & Poor’s 500 Index gained 1.8 percent in 2014 including reinvested dividends.

Cheapest Levels

Treasuries were at the cheapest levels in two months, based on closing prices, according to the term premium, a Columbia Management model that includes expectations for interest rates, growth and inflation. The gauge was at 0.55 percent. A value of 0.50 percent to 0.75 percent is considered normal for a developed-market economy with slow inflation. The average over the past decade is 0.20 percent.

“It’s becoming obvious to the market the Fed is not going to be as supportive of Treasuries,” said Dan Heckman, a senior fixed-income strategist in Kansas City, Missouri, at U.S. Bank Wealth Management, which oversees $115 billion.

Investors added $390.8 million into exchange-traded funds of U.S. fixed income securities as of yesterday, compared to the 20-day average of $569.2 million in inflows, suggesting a diminished appetite for debt, according to ETF data compiled by Bloomberg.

Investors added $9.269 billion into ETFs investing in U.S. stocks, above the 20-day average of $1.571 billion in inflows, Bloomberg data show.

Inflows into fixed-income are still out-pacing inflows into U.S. equities as U.S. fixed-income ETFs have taken in $9 billion so far this year, compared with $1.173 billion in outflows from domestic equity funds, Bloomberg data show.

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