U.S. Government Bonds Pull Back as Fed Statement Looms

By Min Zeng 

        U.S. Treasury bonds retreated Wednesday ahead of the Federal Reserve's statement that may shed light on whether it would start raising benchmark short-term interest rates in September or wait longer to act.
        New debt sales also contributed to lower bond prices. The Treasury is scheduled to auction off $35 billion in five-year notes at 1 p.m. Wednesday and $29 billion in seven-year notes Thursday.
        In recent trading, the yield on the benchmark 10-year Treasury note was 2.271%, compared with 2.252% on Tuesday, according to Tradeweb. Yields rise as prices fall.
        The yield on the two-year note, the most sensitive to changes in the Fed's interest-rate outlook, was 0.704%, near the highest level of the year, compared with 0.67% Tuesday.
        Fed officials will conclude a two-day policy meeting Wednesday afternoon and are scheduled to release an interest-rate statement at about 2 p.m. ET. A post-Fed meeting news conference isn't scheduled.
        The Fed's ultra-loose monetary policy following the 2008 financial crisis has sent prices of many stocks and bonds to elevated levels, raising concerns whether financial assets could hold up once the Fed starts a tightening campaign for the first time in nearly a decade.
        The $12.7 trillion U.S. government debt market is imperative to not only the U.S. economic outlook but also to the health of global financial markets. The yield on the benchmark 10-year Treasury note is used to price a wide range of financing activities including mortgages, corporate bond supply and business loans.
        U.S. bond yields have risen in recent months as investors shed holdings on worries that higher interest rates from the Fed would shrink the value of outstanding bonds. But after rising to a nine-month intraday peak of 2.5% in June, the yield has fallen this month as falling commodities and China's stock market turmoil boost demand for safer assets. Many investors are skeptical whether the Fed could start the tightening campaign as soon as September.
        "While we believe the Fed wants to get off of the zero rate bound very badly, we think they will restrain from signaling an imminent rate hike in order to maintain flexibility," said Daniel Mulholland, senior U.S. Treasury trader at Credit Agricole in New York.
        Mr. Mulholland said there will be two nonfarm jobs reports before the Fed's September policy meeting, and Fed officials "would prefer to use the time between the July and September meetings to be sure the economy is ready for a hike by monitoring incoming data."
        Fed-funds futures, used by investors and traders to place bets on central-bank policy, showed Wednesday that investors and traders see a 21% likelihood of a rate increase at the September Fed meeting, according to data from the CME Group. The odds were 17% a day ago and 12% a month ago.
        Many investors have been prepared for the Fed's pending shift. They have been migrating away from shorter-dated Treasurys whose yields are pinned by the Fed's short-term policy rate. With the Fed prepared for a fresh tightening campaign, investors expect yields on shorter-dated notes to be more vulnerable to a rise.
        The preference for longer-dated bonds has resulted in a shrinking yield premium to hold longer-dated debt instead of shorter-dated securities this month, which reflects some concerns that even a modest rate increase by the Fed may restrict the U.S. economic growth and keep a lid on inflation.
        Fed Chairwoman Janet Yellen signaled earlier this month in her semiannual Congressional testimony that the central bank is on track to raise interest rates as the U.S. economy has been strengthening after a recent soft patch.
        Analysts say should the Fed statement signal a brighter assessment on the U.S. economy and downplay lower commodities prices and China's stock market turmoil, it would suggest the central bank is ready to raise rates in September. If the Fed highlight international developments, it could mean Fed officials could hold rates lower for longer.
        Money managers say regardless of the timing for the Fed to tighten, the Fed's signal that this tightening cycle would be gradual and slow would keep a lid on the rise in the 10-year Treasury note's yield. For the 10-year yield to hit 3% or higher this year, they say, the U.S. economy needs to accelerate or wage inflation flares up, which could push the Fed to raise interest rates more aggressively than many investors expect.
        Write to Min Zeng at min.zeng@wsj.com
        (END) Dow Jones Newswires

        July 29, 2015 09:41 ET (13:41 GMT)

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