Do Falling Treasury Yield Signal Rate-Hike Skepticism? Or Rate-Hike Fear?

       

By Min Zeng
        Many see the decline in the yields on the benchmark 10-year Treasury notes over the past few weeks as a sign that investors are skeptical about whether the Federal Reserve could raise rates in September.
        But there is another camp in the bond market arguing that the decline actually signals increasing speculation that the Fed will raise rates as soon as next month. They say lower yields reflect investors' concerns that even a modest uptick in the Fed's benchmark interest rate could hurt the U.S. economy, which has been recovering more slowly from the recent recession compared with precious cycles.
        "Some camps feel that if the Fed tightens, fundamental growth will be materially impaired," says Russ Certo, managing director of rates trading at Brean Capital.
        The yield on the benchmark 10-year Treasury note fell to 2.15% in late Monday, a two-month low, compared with 2.207% on Friday. The yield has dropped after touching 2.5% in June, the highest intraday level since September. Yields fall as prices rise.
        The 10-year Treasury note yield is a key barometer for global investors and policymakers to gauge inflation expectations and the outlook for the economy. The yield is a benchmark to set long-term borrowing costs for U.S. consumers and businesses.
        Mr. Certo pointed to a shrinking yield spread between short-term and long-term Treasury bonds as a sign that investors are prepared for the Fed's fresh tightening campaign as soon as September.
        Investors have been charging a shrinking yield premium to hold the benchmark 10-year note instead of a two-year note over the past month as Fed officials including Chairwoman Janet Yellen said they were on course to raise interest rates later this year as the labor-market outlook brightened.
        The yield premium fell to 1.485 percentage point recently Monday, the lowest level since the end of April. The gap has shrunk from 1.76 percentage point a month ago. The two-year note's yield ticked lower to 0.665% Monday, but still near the peak of the year.
        The smaller yield spread is known as a flattening yield curve. Many investors are migrating money from short-term notes into long-term bonds. The allocation reflects investors' expectations that the Fed will be more successful in controlling short-term bond yields because they are pinned to the Fed's key policy rate--the fed funds rate. Yields on longer-dated bonds are influenced by a variety of factors, especially the outlook for inflation, which chips away bonds' fixed return over time.
        The positioning is evident in the Treasury futures market.
        Investors including hedge funds and money managers have accumulated $6.56 billion in net long positions on 10-year Treasury note futures, for the week that ended July 28, according to data from Cheng Chen, interest-rate strategist at TD Securities. It represents the biggest weekly net long since April 2013. A long bet wagers on prices of bonds to rise. The opposite is a short bet.
        In contrast, the value of net shorts on the five-year Treasury futures was $16.2 billion for the week that ended July 28, the highest level since March 2014.
        To be sure, the Fed has signaled that it will remain highly accommodative even if it raises rates this year. But some investors are concerned that a move in September could jolt sentiment at a time when a selloff in commodities are reducing inflation expectations. Meanwhile, higher rates from the Fed could send the U.S. dollar higher still, hurting U.S. exports and making it more difficult for the Fed to fulfil its mandate by pushing inflation up to its 2% target in the medium term.
        "The environment of low inflation and subdued global growth remains a favorable backdrop for U.S. fixed income, despite the potential for the Fed tightening," said Erik Schiller, senior portfolio manager at Prudential Financial Inc.'s fixed-income unit, which has $560 billion in assets under management.
        Mr. Schiller said that if the Fed tightens into this backdrop, "it may be premature" and could help to slow the economy and lower inflation expectations. That is providing support to prices of longer-dated bonds, he said.
        (END) Dow Jones Newswires

        August 03, 2015 15:43 ET (19:43 GMT)

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