Treasuries Rally as Traders Awake to Recast China-Fed Conundrum

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Treasuries rose as traders awakened to news that China devalued the yuan, weighing on commodities and emerging markets, and prompting speculation that the Federal Reserve may delay an increase in interest rates.

U.S. government securities also rallied as China’s announcement boosted demand for dollar-denominated assets. The People’s Bank of China cut the yuan’s daily reference rate by the most in two decades to combat a slump in exports, dragging down Asian currencies and pulling European stocks lower.

“Since I woke up, I’m just trying to sift through all the information,” said Craig Collins, managing director of rates trading at Bank of Montreal in London. “Does this put the Fed on hold? I don’t know. The U.S. is paying attention to what’s going on in Europe and Asia and it does influence, to a degree, the growth prospects for the U.S.”

Ten-year U.S. note yields fell five basis points, or 0.05 percentage point, to 2.18 percent at 7:39 a.m. New York time, according to Bloomberg Bond Trader data. The 2.125 percent security due May 2025 climbed 15/32, or $4.69 per $1,000 face amount, to 99 17/32.

The securities will struggle to break convincingly through their Aug. 7 high of 99 22/32 before U.S. markets open, according to BMO’s Collins.

Packing Punch

The spread between yields on two- and 30-year Treasuries will widen “if the market begins thinking this packs enough punch that it’s going to delay interest rates hikes into 2016,” he said. The spread narrowed two basis points to 215 basis points on Tuesday.

U.S. two-year yields, among the most sensitive to interest rates, declined two basis points to 0.70 percent.

The U.S. is set to auction $64 billion of coupon-bearing debt this week in three parts, beginning with a sale of three-year notes on Tuesday. Such securities were last sold on July 7 with a yield of 0.932 percent and yielded 1.06 percent in pre-auction trading.

A delayed start to the Fed’s rate-increase cycle is exactly what Hideo Shimomura, the chief fund investor at Tokyo-based Mitsubishi UFJ Kokusai Asset Management Co., thinks will happen after China’s devaluation.

“It’s a game changer,” he said. “If the Fed starts to hike rates in September, it will bring stress to the markets.”

Policy makers have kept the U.S. benchmark interest rate near zero since 2008 to support the world’s largest economy.

Traders are pricing in a 48 percent chance the Fed will raise borrowing costs at its Sept. 16-17 meeting, down from 54 percent on Aug. 7, based on the assumption that the benchmark rate will average 0.375 percent following the increase, data compiled by Bloomberg show.

The odds of the rate being lifted further by March slipped to 53 percent, from 58 percent at the end of last week.

The dollar advanced against 13 of its 16 major peers, helping to boost the allure of U.S. bonds over other government debt including German bunds.

“China’s devaluation is bullish fixed income, particularly Treasuries if the market factors in more activity in currency markets going forward,” Peter Chatwell, a rates strategist at Mizuho International Plc in London, wrote in an e-mailed note. The move “is another reason for us to expect Treasuries to outperform bunds.”

(An earlier version of this story corrected the Fed rates odds in the third paragraph from the end.)