Bond Traders' Mantra Is Don't Fear the Fed as Rate Hikes Ramp UpBy and
T. Rowe, AllianceBernstein say a 3% 10-year yield is alluring
Flattening curve, vanishing term premium signal confidence
The world’s biggest bond traders see no reason to shy away from long-term Treasuries as the Federal Reserve is on the brink of its most aggressive round of rate hikes in more than a decade.
Tightening cycles have historically spurred outperformance in long-maturity debt, and managers of more than $1 trillion of fixed-income assets say this time’s no different. That confidence flies in the face of projections that the government’s debt burden will balloon by $10 trillion in the next decade, even before taking into account Trump administration plans to jumpstart the economy.
In the $13.9 trillion Treasuries market, signs abound that holders of longer-dated obligations see little risk of a substantial acceleration in growth and inflation: The term premium on 10-year notes dipped below zero last month for the first time since November; traders are paying just as much to protect against inflation over the next few years as a decade out; and there’s unprecedented demand for strips, one of the most bullish bets in the bond market.
“We don’t necessarily think this is going to be a major trend change, and that we have a longer-term break out of the downtrend in yields,” said Steve Bartolini, portfolio manager of inflation-focused strategies at T. Rowe Price Group, which oversees $188 billion of fixed-income. If benchmark 10-year Treasury yields climb to 2.75 percent or 3 percent, “those are levels we would consider adding to duration.”
Traders view a quarter-point Fed hike March 15 as a virtual certainty after Friday’s data showed U.S. employers added more jobs than forecast in February. Futures also indicate the market’s moving toward policy makers’ December projection of three rate increases in 2017. It would be the first year with multiple Fed hikes since 2006.
Investors can look to the past three tightening cycles for reassurance that long-term bonds are the place to be.
At almost 107 basis points Monday, the spread between five- and 30-year Treasuries was near a nine-year low, though that’s no barrier to further declines. From June 2004 to June 2006, the curve flattened to 5 basis points, from 147 the day before the first hike. From June 1999 to May 2000, it dropped to minus 52 basis points from 45. And from February 1994 to February 1995, it fell to 9 basis points from about 101.
There’s reason to suspect that history could be upended this time. For one thing, the U.S. debt load, already unprecedented, will swell 67 percent in the next decade, judging by Congressional Budget Office estimates. What’s more, Treasury Secretary Steven Mnuchin is considering issuing bonds due in 50 or 100 years, potentially reshaping the yield curve. And the recent leap in yields is spurring debate over whether the bond bull market is about to end, possibly driving up yields across maturities.
Yet indicators across the debt market show investors don’t expect longer-term yields to move much higher, let alone spiral out of control.
Helping depress long-term yields, the term premium -- a measure of the compensation that investors demand to hold longer maturities -- is almost non-existent.
The 10-year term premium has averaged minus 0.25 percentage point since the start of 2016, compared with positive 1.79 percentage points from 1961 through 2006, according to a New York Fed model.
A negative term premium rarely occurred before the Fed’s bond-buying programs. The central bank still holds $2.5 trillion in Treasuries on its balance sheet as part of steps to support the economy, and the hoard may barely shrink.
“This tightening cycle is happening from a very low base, and also in the context of the historically unprecedented size of the Fed’s balance sheet,” said Tony Rodriguez, who oversees $140 billion as co-head of fixed-income at Nuveen Asset Management. “That helps keep longer rates from moving higher than they otherwise would.”
Inflation is among the biggest drivers of higher long-term yields. And while a bond market signal of price-growth expectations has soared, topping 2 percent, lately it’s suggested that traders don’t expect the reflationary boost to last too long.
For the first time since the recession, the five-year break-even rate has eclipsed the 10-year this year. The gauge, derived by calculating the difference between yields for nominal and inflation-linked bonds, indicates traders don’t see price growth accelerating very much over the next decade.
“The TIPS curve is the market saying that we know short-term, things are going to be good, but long-term, we have some doubts because things like the debt overhang and demographics give us some pause in expecting 3, 4 or 5 percent inflation,” said Scott DiMaggio, who helps oversee $270 billion as director of global fixed-income at AllianceBernstein in New York. “The market doubts that a fiscal thrust will really lead to sustainable higher potential growth.”
Perhaps the biggest reason DiMaggio doesn’t expect much higher yields is because interest rates remain near record lows in Japan and Europe, where central banks are still buying debt to push down borrowing costs.
The extra yield on 10-year U.S. debt over German securities rose in December to the highest since 1989, boosting Treasuries’ appeal. The advantage over Japan is near the most since 2010.
And then there’s strips, arguably the biggest bet on duration an investor can make. The amount created is at an all-time high even though the instruments were crushed as interest rates surged after the election.
Franco Castagliuolo at Fidelity Investments said he has a neutral position on duration, leaving room to maneuver as policies from the Fed and the Trump administration become clearer.
“It’s not necessary to be heavily underweight the long-end of the yield curve right now,” said the portfolio manager, whose company oversees more than $875 billion in fixed-income.
“I’m not forecasting there to be these very powerful, pro-growth, animal-spirit-driven forces,” he said. “I’m not particularly skittish about rates right now.”