The bond market is finally beginning to believe the Federal Reserve is serious and that other central banks may stop filling the punch bowl of easy money.
That talk was partly behind the global bond market sell off Friday that hit Treasury prices and swept yields higher. The
U.S. 10-year yield temporarily rose to the key 3 percent mark. Ironically, the rout comes on the eve of the tenth anniversary of the failure of Lehman Brothers, a catastrophic event for financial markets that forced the Fed and other central banks into extreme easing policies they are just beginning to unwind.
Investors have been doubting the Fed will follow through with the two rate hikes it forecasts for this year and three for next year. The futures market had been anticipating a September rate hike, but this week, fed funds futures began to reflect an 80 percent chance of a hike in December, a sharp jump from last week’s expectations of about 60 percent. For next year, the futures now reflect nearly two rate hikes while previously one was barely priced in.
The bench mark 10-year yield is a widely watched metric since it is linked to many business and consumer loans, including home mortgages. Yields rise inversely to bond prices.
Strategists pointed to multiple reasons behind Friday’s global surge in yields, which rise as bond prices fall. But all agreed, the selling was linked in part to the tone from the European Central Bank meeting Thursday, at which ECB President Mario Draghi once more signaled an end to the bank’s bond buying program.
“I think it’s the central banks for years have been big tailwinds for the markets. They’ve been super helpful for equities and they’re becoming a little bit of a headwind,” said Michael Schumacher, director rates strategy at Wells Fargo. “The Fed is getting company from the ECB and maybe the Bank of England…central banks are switching from being super-stimulative to stimulative.”
Nomura’s George Goncalves said expectations are being driven by tough talk by the Fed, and it could sound hawkish again when it meets to raise interest rats Sept. 26. Even officials, like Fed Gov. Lael Brainard, viewed as a dove, said Thursday that the Fed could raise rates for some time without slowing the economy.
“All the doves at the Fed sound a little more on the hawkish side,” he said. “What’s impressive is it happened even though we had weaker data,” said Goncalves, head of U.S. rate strategy. “It’s the second day after Draghi’s statement, and everyone thinks central banks are going to be dovish forever. Although he didn’t really say anything new, what was strikingly hawkish is they’re clearly going to exit away from ultra-accommodation, and their bond markets are the most aggreggiously mispriced in the last couple of years.”
Stronger U.S. inflation, though not apparent in CPI this week, and better growth is supporting higher rates in the U.S., which strategists say have been too low. The 10-year yield’s move above 3 percent was for the first time since August, and the 30-year rose to 3.13 percent. In Europe, Germany’s 10-year bund rose to 0.44 percent and the French sovereign reached 0.77 percent.
The 10-year yield pushed above 3 percent in April, May, June and again in August, but it has failed to hold the elvel for very long, and made a high of 3.128 percent in May.
“I think what we have to recognize is if we strictly looked at the fundamentals of the market, we should be between 3 and 3.25 percent. I don’t think we should be above 3.25 percent. It doesn’t mean we should be at 4 percent,” said Jim Caron, fixed income portfolio manager at Morgan Stanley Investment Management. “But every time we’ve gotten here, some kind of news came out , whether it’s trade related or an [emerging markets] event that pushed rates lower. Interest rates, left to their own devices, would push higher.”
Caron expects the Fed to raise rates another percentage point, or four times, before pausing. “What we’ve seen for the first time this summer is a two week period where things have actually gotten better,” he said. He said some of the concerns with Italian debt have faded as politicians there appear more willing to work within European Union rules.
“The other thing is that Argentina, they’ve been doing all the right things, going to the IMF, hiking interest rates,” he said, adding that Turkey has also moved to raise interest rates. Reports that China and the U.S. will talk on trade is also a catalyst, and there are positive signs that the U.S. and Canada are trying to work out their differences on trade. Bloomberg headlines at noon Friday that President Donald Trump wants to move ahead with tariffs on China did take some of the steam out of higher yields, but did not reverse the sell off.
“It’s a global phenomena. They’re all moving on the Fed and now the ECB is saying similar things,” said Andrew Brenner of National Alliance. “This is not running on data. It’s running on technicals. The Fed’s moving. The Fed’s not stopping. Supply is coming. We’re funding the tax plan with deficit spending.”
The big move in yields follows three auctions this week for 3- and 10-year notes and 30 year bonds. It also comes as corporate issuance surges, with nearly $90 billion in new debt in just the past two week, according to Informa Global Markets.
Brenner said the next level he’s watching on the 10-year yield is 3.128 percent, the year high, and he’s watching 3.25 percent on the 30-year. “If those two things break, it’s lights out to the next level,” he said.
He and other said one factor that may be contributing to rate rise is the fact that pension fund buying in bonds could be slowing for now, after a surge in buying ahead of a mid-September tax deadline. Under the new tax law, corporate pension sponsors had until Sept. 15 to deduct contributions at last year’s rate instead of the new 21 percent rate. Strategist said that did not drive rates higher, as much as it may have removed a supportive buyer from the market.
Goncalves said a bigger factor is the fact that central banks are increasingly removing stimulus though the ECB did not reveal anything new. “I think markets are realizing they’re unwaivering. Tehy’re slipping into tightening, and that’s putting pressure on European rates. That’s going to put upward pressure on ours. You couple that with the idea that deficits are gogn to tart to mattter in the U.S., it’s a perfect debt supply cocktail that’s going to push U.S. rates higher,” he said.
Goncalves said he ultimately expects a 3.5 percent 10-year yield, but in 2019. At that point, yields could challenge the stock market, as investors may see more yield in bonds.
Schumacher said the move higher in yields Friday was unusual since typically after 30-year bond auctions, yields move lower. The auction was Thursday.
“As an investor or hedger or whatever you have to pay a lot more attention to the Fed and say maybe they’re going to do this… I think it’s partly the sense that inflation is picking up a little bit,” said Schumacher. He said the market took the near 3 percent surprise annual jump in average wages, reported in last week’s August payrolls data far more seriously than CPI, which was weaker than expected this week. “The wages thing shocked people.”