Bond Investors' Dash for Safety Tramples Cushion Against Shock

  • Term premium approaches 45-year low as yields plummet
  • Three-month, 10-year yield gap touches smallest since 2012

Investors have seldom been gloomier about prospects for the global economy, judging by this week’s Treasury-market performance.

As worries about European banks’ credit pushed global stocks into a bear market, demand for U.S. debt heated up, driving benchmark 10-year yields toward record lows.

During the Treasuries rally, investors discounted the risk of any surprise jump in interest rates or inflation by the most since January 2015, according to a gauge known as the term premium. The measure of how much extra return investors demand against unexpected developments over the life of the security approached the 45-year low set during last year’s global deflation scare, going by the Federal Reserve Bank of New York’s favored formula.

The metric didn’t dive so steeply during last month’s declines in stocks and oil, or during August’s financial-market volatility. The drop was more severe this time because the concern about bank creditworthiness heightened speculation that global economic weakness will damage the U.S. financial system, said Priya Misra, head of global interest-rates strategy with TD Securities LLC in New York. The cost of contracts insuring debt against default soared this week for both Credit Suisse Group AG and Deutsche Bank AG.

“When banks come under question, or there are concerns around credit risk, the rates market takes that much more seriously,” Misra said. “Banks are so highly linked with growth and credit creation that markets say this is going to affect growth.”

Fed Odds

That concern pushed the yield on the benchmark 10-year Treasury as low as 1.53 percent this week, the lowest in more than three years and within 15 basis points of the historic low reached in 2012. For the week, the yield fell nine basis points, or 0.09 percentage point, to 1.75 percent. The 1.625 percent security maturing in February 2026 was at 98 7/8.

The collapse in the term premium came as traders raised questions about the Federal Reserve’s ability to raise interest rates. At one point Thursday, traders were betting there was a higher chance of a rate cut by the end of 2016 than another increase. The Fed boosted borrowing costs for the first time in nearly a decade in December, and policy makers projected four rate increases in 2016.

By the close of trading Friday, the market-implied chances of a rate cut by the end of 2016 had fallen to about one percent. Traders assign a 30 percent chance of a quarter-point increase by the end of 2016, down from a 93 percent probability seen at the end of last year.

Market Stress

Signs of distress were also evident in the Treasuries yield curve. It has yet to flash the traditional recession signal -- short-term yields climbing above long-term yields. But that difference has shriveled. The gap between three-month and 10-year yields, which the Cleveland Fed uses as a growth indicator, narrowed to the smallest since 2012. The spread between two- and 10-year yields shrank to the slimmest since 2007.

“It is difficult to be optimistic about the curve,” Shyam Rajan, head of U.S. rates strategy at Bank of America Merrill Lynch, wrote in a Friday note to clients. It sends “a far more pessimistic message” than the last time 10-year yields reached these levels.

The pessimism put the iShares 20+ Year Treasury Bond ETF on pace to extend its longest string of weekly inflows ever. As of Thursday, it had attracted $701 million for the week, after bringing in a net $2.8 billion during the past eight weeks, data compiled by Bloomberg show. That means it’s brought in more than a third of its assets this year.

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