2-Year U.S. Government Bonds Retreat, 10-Years Strengthen

By Min Zeng 

        Shorter-dated U.S. Treasurys pulled back Friday, while longer-dated bonds strengthened as the latest U.S. employment report bolstered the case for the Federal Reserve to raise interest rates next month.
        Yields on shorter-dated securities in the bond market are the most sensitive to changes in the Fed's rate policy outlook. The two-year note's yield rose to near the highest level of the year. Yields rise as prices fall.
        As the prospect grew for the Fed to start raising interest rates in six weeks for the first time since 2006, investors migrated cash out of shorter-dated notes and into longer-dated bonds. The allocation pushed up prices of the 10-year and 30-year Treasury bonds and lowered their yields.
        The jobs gain of last month--215,000--met economists' forecasts but continued to show solid growth in the labor market. Fed officials signaled last month that some further improvement in the labor market could be sufficient to start dialing back crisis-era ultraloose interest rate stimulus for the economy.
        Ultralow interest rates since the financial crisis have stoked a rally in the $12.7 trillion market for U.S. government bonds and other credit markets. Many investors are concerned that the start of a tightening cycle would shrink the value of existing bonds.
        The yield on the two-year note rose to 0.741% in recent trading, compared with 0.708% Thursday, according to Tradeweb.
        "This certainly gives the Fed a reason to raise rates in September if they want to, and the bond market is adjusting," said Christopher Sullivan, who oversees $2.4 billion as chief investment officer at the United Nations Federal Credit Union in New York. "Fed officials have signaled that some further improvement in the labor market could be enough to tighten and this jobs report was a solid one."
        The odds of a rate increase at the September meeting were 58% Friday, compared with 46% before the jobs report and 48% Thursday, according to Traders. The calculations are based on implied yields from Fed-funds futures which are used by investors and traders to place bets on central-bank policy.
        The odds of a rate boost at the December meeting were 79.6%, compared with 72% before the report and 73% on Thursday.
        "The Fed has every reason to dial back its zero-interest-rate policy," said Scott Clemons, chief investment strategist at Brown Brothers Harriman, which has $26.8 billion assets under management as of the end of June.
        Mr. Clemons said he expects a 25-basis-point rate increase in September, which still leaves the Fed's policy accommodative. With contained inflation, the Fed's path of tightening would be gradual, which should reduce the risk of market turmoil, he said.
        Federal Reserve Bank of Atlanta President Dennis Lockhart said Tuesday that it would take a significant deterioration in the data to convince him not to move in September.
        The yield on the benchmark 10-year note was 2.209%, near a two-month low, compared with 2.236% Thursday.
        Yields on longer-term bonds are affected by a broad range of factors including global growth outlook and inflation. The latter chips away bonds' fixed return over time.
        Investors have been charging a shrinking yield premium to hold longer-dated Treasury debt instead of shorter-dated notes over the past month. Friday, the premium dropped to 1.472 percentage point, the slimmest since April, a sign investors are girding for a potential rate increase in September.
        Money managers say the allocation away from shorter-dated notes and into longer-dated bonds suggests some concerns that with the global economy remaining sluggish, the Fed's tightening campaign, even on a measured pace, could hurt the U.S. economic outlook.
        The 10-year yield has dropped from 2.5% made in June, which was the highest intraday level since September. Falling commodities prices and China's stock market turmoil have clouded the global economic outlook and boosted demand for ultrasafe U.S. government debt. The yield is a barometer for global investors and policy makers to gauge on the health of the economic and inflation outlook.
        Write to Min Zeng at min.zeng@wsj.com
        (END) Dow Jones Newswires

        August 07, 2015 10:16 ET (14:16 GMT)