The yield on the 10-year note has spiked as high as 2.23% in recent days, up more than 60 basis points from the May meeting of the Federal Open Market Committee (FOMC). In recent trade, the yield was around 2.10%.
After the May 1 meeting, volume surged. Icap, the largest inter-dealer broker of US government debt, says the average daily trade in treasuries it handled in May jumped more than 40% to $189.9 billion, from $135.1 billion in the first quarter.
The sell-off was sparked by the FOMC hinting for the first time at the possibility of tapering its asset purchases. However, the committee also said it might increase purchases.
“There has been quite a significant sell-off in the treasury market during May, but stepping back a bit, the big picture really is that monetary policy remains quite supportive for the bond market,” says John Higgins, head of global economics at Capital Economics.
“The ebb and flow of the market is being influenced by investors’ perceptions of what’s going to happen to quantitative easing (QE), but interest rates themselves we expect to remain at rock-bottom levels for a long time to come and that is likely to mean that yields remain pretty firmly anchored.
“We wouldn’t expect yields to rise significantly higher than they are now and they could well fall back below 2% by the end of this year. It’s easy to get excited by recent moves, but they’re pretty small beer in the wider picture of things.”
Higgins notes that yields have been anchored close to 2% for a considerable period by close-to-zero interest rates and that he does not expect that to change much until the Fed starts to hike rates, which is unlikely before mid-2015 at the earliest.
“Based on past tightening cycles, on average, yields only started to rise in earnest about seven months before the Fed actually hiked interest rates,” he says. “It is quite possible that the market will react earlier than it has to any sign that the Fed is taking away the punch bowl – reducing its purchases – but there’s a big difference between taking your foot off the accelerator and applying the brake.”
Higgins adds that while the Fed might take its foot off the accelerator towards the end of this year, he does not see it selling any of it holdings until one or two years after it hikes interest rates.
Investors in treasuries have been selling on expectations that prices will fall – a strategy predicated on the Fed scaling back its $85-billion-a-month in asset purchases later this year.
The monetary easing policy – quantitative and qualitative – has been supporting bond prices and keeping interest rates low. That has given a boost to the housing market by reducing mortgage rates, putting more money in consumers’ pockets.
However, while positive recent jobs data have been fuelling expectations for the tapering of QE, the policy has yet to produce the durable economic recovery hoped for.
While the economy expanded for the 48th consecutive month in May, growth has been sluggish, prices stagnant and unemployment remains stubbornly high – 7.6% in May, up from 7.5% in April, despite the stronger-than-expected job growth of 175,000 last month.
What’s more, the ISM Manufacturing survey for May contracted after expanding for the previous five months. The survey recorded across-the-board falls in purchasing, new orders, production and prices.
Inflation is headed in the opposite direction – slowing to 0.7% in April compared with 1% in March – to the Fed’s 2% target. It has also pledged to keep its target interest rate close to zero until unemployment falls to 6.5%. In other words, inflation and unemployment are above the Fed’s target.
Guy Foster, head of portfolio strategy at Brewin Dolphin, says he expects to see more “dovish Fed-speak” for the time being to try to bring the increase in yields under control.
“If yields were to go much beyond 2.5% on the 10-year, then the likelihood is that the Fed would be very keen to halt that appreciation,” he says.
“If yields start going up very sharply, then the Fed is going to be concerned that will choke off the recovery, so they’ll make it clear they still ‘stand there ready to support the economy’.
“I think 2.1% is still a pretty low 10-year government bond yield, but if you go from 1.7% to 2.5%, for example, quite quickly, then that starts to look like a big move.”
He adds: “But everything that’s going to happen for the immediate future is through language. We still don’t expect there to be any significant tapering this year, so the aspect of stimulus that’s being removed is the forward guidance rather than the actual flow.”
Foster says the Fed is anxious to avoid a repeat of 2006 and 2007, when it feels it provided too much guidance on the direction of monetary policy, allowing speculators to take advantage of how they expected the policy environment to proceed.
“If the Fed says ‘we’re reducing the rate of purchases’, then that becomes an open invitation to hedge funds to short the treasury market and in doing so they’re hurting the economy and achieving very low risk profits for themselves,” he says.
“By going from saying it’s buying $85 billion of assets a month until further notice to saying it might reduce it but it might not, the Fed is trying to allow yields to rise slowly but without providing enough incentive for investors to mount some kind of speculative attack on the treasury market.”
Foster concludes: “I don’t think it would be very surprising if you saw the Fed appear to flip-flop that nobody a bit along the way.”