U.S. Government Bonds Strengthen

By Min Zeng 

        U.S. government bonds recovered from an early pullback to strengthen Thursday as weaker stocks and crude oil prices boosted demand for safer assets.
        The yield on the benchmark 10-year Treasury note recently fell to a two-week low of 2.286%, compared with 2.322% Wednesday, according to Tradeweb. Yields fall as prices rise.
        Treasury bond yields had risen earlier in the session as an upbeat labor market report brightened the U.S. economic outlook. The latest weekly jobless claims fell to the lowest level since 1973, which bolsters the case for the Federal Reserve to start raising benchmark short-term interest rates as soon as September. A shift in the Fed's loose monetary policy would shrink the value of outstanding bonds.
        The report sent the yield on the two-year Treasury note to 0.727%, near the highest level of 2015. Yields on shorter-dated notes are the most sensitive to changes in the Fed's rate outlook. The yield was recently at 0.702%, little changed from 0.706% on Wednesday.
        Shorter-dated Treasury notes have been lagging as investors cashed out of these maturities and moved cash into longer-dated bonds to prepare for the Fed's tightening plan.
        Investors have been demanding a lower premium to hold the benchmark 10-year Treasury note instead of the two-year note. The shrinking premium is known as a flattening yield curve.
        On Thursday, the premium was 1.584 percentage point, the lowest level since early June.
        "The bond market is adjusting," said Donald Ellenberger, head of multisector strategies at Federated Investors Inc., which had $355.8 billion in assets under management as of March 31. "But no one is certain whether the Fed is able to tighten in September or not."
        Mr. Ellenberger said the two-year note's yield could rise to 1% at the end of this year should the Fed start raising rates in September and the 10-year yield could rise to 2.75%. He said the rise in longer-dated bond yields would be contained without signs that wage inflation is flaring up.
        The resumption of a selloff in commodities this month is clouding the global economic outlook and potentially complicating the Fed's policy adjustments. Weaker oil prices have reduced expectations about inflation, a main threat to longer-dated bonds.
        Treasury yields have risen over the past few months after a decline earlier this year. The 10-year yield hit this year's intraday peak of 2.5% in June, the highest level since September. The yield was 2.173% at the end of last year.
        Yields remain very low from a historical standpoint. Many investors don't expect the 10-year yield to rise sharply, citing the moderate pace of U.S. economic growth and contained wage inflation. Ms. Yellen said this tightening cycle would be gradual and slow, also reducing investors' worries of a spike in the yield.
        "A removal of the stimulus, especially if it results in continued dollar strength, could very well result in a pullback in economic activity," said Michael Collins, senior portfolio manager at Prudential Financial Inc.'s fixed-income unit, which has $560 billion assets under management. "The decline in commodity prices will likely keep inflation expectations, and [longer-dated yields], in check."
        Fed-funds futures, used by investors and traders to place bets on central bank policy, showed Thursday that investors and traders see a 17% likelihood of a rate increase at the September Fed meeting, according to data from the CME Group.
        The odds were little changed from a month ago.
        The Fed's next policy meeting is scheduled for July 28-29. The Fed has held the policy rate--the fed-funds rate--near zero since December 2008.
        "The Fed hikes more if it is ignored by markets, but slows down if a market selloff gets out of hand," said David Keeble, head of fixed-income strategy at Credit Agricole. "After six years of manipulating the bond market, they have a lot of expertise."
        Write to Min Zeng at min.zeng@wsj.com
        (END) Dow Jones Newswires

        July 23, 2015 14:14 ET (18:14 GMT)

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