In bond market rout, investors see lagging correction

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Investors often claim that the US government bond market is the best place to learn about the changing outlook for the economy and for interest rates. Right now, some think it doesn’t.

In the closing days of the third quarter, yields on US government bonds soared. This could be seen as an encouraging sign of the outlook for the economy as yields, which rise when bond prices fall, generally tend to rise with expectations of growth and inflation.

Many analysts, however, don’t believe yields are rising now, as the economic trajectory has changed so much. Rather, they see the bond sell-off as an expected correction from an exaggerated rally – the product of profit taking more than a major shift in mindset.

The reason why yields rise is important because it can influence the reaction of investors in other markets. All other things being equal, higher yields can hurt stock prices by raising companies’ borrowing costs and reducing the value of future earnings. But investors can also welcome them if they feel that rising yields reflect an improvement in growth prospects.

In this case, investors have registered a mixed reaction. Most are optimistic about the economy, but their perspective hasn’t changed much since last week, when yields were lower. Stocks have been volatile, first climbing when yields started to rise and then falling sharply earlier this week.

Many investors waited for bonds to suffer. After hitting a pandemic high of 1.749% on March 31, the 10-year yield fell to 1.173% on August 2 and remained below 1.4% until the end of last week. But even in August, many continued to believe that yields were abnormally low and should rise.

“I don’t think there’s really anything particularly fundamental going on,” Blake Gwinn, head of US rate strategy at RBC Capital Markets, said on August 2 as yields fell. Some investors, he said, were buying bonds when they still could, aware that prices would likely come down at some point, but confident they wouldn’t in the very near future. Others with long-held short positions were inclined to sell but were apprehensive after being scorched by the rally.

Mr Gwinn had guessed that the momentum would only really change after the Federal Reserve meeting on September 21-22. Before resetting their positions, he said, investors were almost waiting for this meeting when the Fed would likely take a “tangible turn” towards tightening monetary policy.

Seven weeks later, that’s more or less what happened. On September 22, the Fed signaled that it would likely start reducing its purchases of treasury bills and mortgage-backed securities as early as November. Officials have also indicated that they may raise short-term interest rates sooner and faster than previously expected.

None of these developments shocked investors, and returns were little changed immediately after the meeting. The next day, however, investors started shedding Treasuries, reducing the 10-year yield to 1.540% on Wednesday.

As the sale began on September 23, Mark Lindbloom, a fixed income portfolio manager at Western Asset, claimed people like him were driving him. That day, Mr. Lindbloom’s team had reduced bets on the outperformance of longer-term Treasuries. “Our portfolio position benefited our clients,” he said, but it was time to “take some out, just to hedge our bets a bit.”

Many analysts still attribute at least part of the recent rise in yields to an improving economic outlook.

The past few months have been marked by disappointing economic data, including an August retail sales report that is well below expectations. In September, however, the same report, covering sales in August, was much more encouraging – suggesting the economy was resisting the surge in Covid-19 cases spurred by the highly contagious Delta variant. Signs that the Delta wave may have peaked in the United States have also given investors hope that more workers will return to their offices, leading to further economic gains, said Thanos Bardas, global category co-head of the category. investment and senior portfolio manager at Neuberger Berman.

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There may be a limit to how high returns can climb from here. In recent months, many analysts have stuck to predictions that the 10-year yield could reach 1.75% or 2% by the end of the year. But their expectations of returns beyond that point are limited by longer-term trends.

More importantly, longer-term Treasury yields are usually driven by short-term interest rate expectations set by the Fed. But over the past few decades, the central bank has let its benchmark federal funds rate progressively lower due to a variety of factors, including slowing potential economic growth, analysts said.

As it stands, the so-called neutral interest rate that neither stimulates nor slows the economy could be just below 2%, analysts at Cornerstone Macro estimated in a recent report. This suggests that the central bank would find it difficult to raise rates above that threshold, putting a soft cap on Treasury yields as it were.

While investors can sometimes anticipate that the Fed could raise rates above the neutral level, “it is very difficult, mathematically, to envision, say, a 10-year Treasury yield of 3% when the nominal neutral rate is is less than 2%, ”they wrote.

Write to Sam Goldfarb at [email protected]

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