The $21tn US government bond market is in for a “bumpy” ride, investors warn, after a tumultuous quarter marked by the worst performance for long-dated Treasuries in more than four decades.
US borrowing costs have jumped since the start of 2021 as a brightening economic outlook, amplified by the Biden administration’s $1.9tn stimulus programme, has dented the allure of Treasuries.
As economists have rushed to revise higher their growth and inflation forecasts — in some cases to such an extent that some believe the Federal Reserve could begin tightening the screws on its ultra-loose monetary policy sooner than expected — the yield on the benchmark 10-year Treasury note has shot higher. Having hovered around 0.9 per cent in early January, it is now just shy of a 14-month peak of 1.78 per cent.
Most strategists had braced for rising yields this year as the economy began to grow again, but the velocity and scale of the retreat jarred even veteran market watchers and have since sparked jitters about the coming months for Treasuries.
“All of us have been caught out,” said Steven Major, global head of fixed income research at HSBC, who has had a longstanding bullish view on bonds. “I suspect [the second quarter] is going to be bumpy.”
A Bloomberg Barclays index of Treasuries maturing in 10 years or longer tumbled 13.5 per cent on a total return basis in the three months ending Wednesday, marking the worst quarter since 1980.
The losses are particularly pronounced given the historically low levels of yields since the Fed pulled its policy rate to near zero last year.
This environment makes bond prices, particularly at the longer end of the maturity spectrum, far more sensitive to interest rate fluctuations, strategists say. Longer-term bonds are also more susceptible to changes in the inflation outlook, since the payments they provide are fixed over a long time horizon and stronger price growth makes these coupons less alluring.
Investors anticipate that US government bond losses will ease, given the magnitude of the moves so far and the relative attractiveness now to foreign buyers seeking out higher-yielding haven assets. But any near-term reprieve is likely to give way to further selling, they warn, especially if the Fed continues its light-touch approach to the recent yield increases.
Investors are also looking towards the $2tn spending plan that US president Joe Biden announced on Wednesday as a potential catalyst for further upgrades to the economic outlook.
Economists are already forecasting US output growth of 5.7 per cent this year, after a 3.5 per cent drop in 2020, according to a Bloomberg survey. Consumer prices are forecast to rise 2.4 per cent.
“It would not surprise me to see rates pause and catch their breath, but I do think we finish the year higher in the 10-year than where we are today,” said David Lebovitz, global market strategist at JPMorgan Asset Management.
The catalyst in the second quarter could stem from higher levels of growth and inflation that exceed even the loftiest of economists’ forecasts.
Lisa Hornby, head of US multi-sector fixed income at asset manager Schroders, said overwhelming evidence of a powerful expansion could make skittish investors even jumpier, inciting volatility and renewing downward pressure on Treasuries. She said the 10-year note could eventually trade with a yield north of 2 per cent.
Sonal Desai, chief investment officer at Franklin Templeton’s fixed income group, warned of significant scope for inflation to return in a more robust and enduring way than many currently expect.
Fed chair Jay Powell has repeatedly said that any burst of inflationary pressures will be shortlived and, as such, the central bank remains committed to keeping interest rates at rock-bottom levels until its average 2 per cent inflation target and employment goals are reached.
“The market is buying what the Fed is selling, which is that there is going to be more inflation,” Desai said. “The danger is a loss of another kind of credibility, [one] related to whether or not they can bring it back down again.” She predicts benchmark Treasuries could trade at or above a 2.5 per cent yield by year-end.
The Treasury department’s huge auctions of new debt could again become the catalyst for more frenetic trading in the coming quarter, traders warn. Liquidity drained from the market after a grim seven-year auction in February. Sales ever since have kept investors on edge.
“We’re in a new paradigm where for every auction going forward we’re going to be analysing the demand, supply . . . and price action [to determine] whether or not we think it is actually going to be a major event or whether it’s going to be something that’s going to clear,” said Jamie Anderson, head of US trading at Insight Investment.
The Fed has not yet expressed concern about the rise in yields, but it has set parameters for the kind of market moves that would worry policymakers.
“The Fed has made it clear that it is not OK if rates are going higher and it hits financial conditions and chokes off the recovery,” said Sara Devereux, global head of rates at Vanguard. “It is also not OK if rates are going higher . . . because of disorder in the market or because of liquidity issues.”