A Bond-Investing Conundrum Returns
June 27 2017 - 7:40PM
Dow Jones News
By Min Zeng
The U.S. bond market is defying the Federal Reserve again.
The central bank has raised short-term interest rates four times
beginning in December 2015 and pushed up the key policy rate by one
percentage point. Yet the yield on the benchmark 10-year Treasury
note settled at 2.198% on Tuesday, below the 2.269% where it
settled before the Fed's first rate increase since 2006. Yields
fall as bond prices rise.
The tension reminds some investors of the "conundrum" described
by Alan Greenspan, then Fed chairman, in February 2005. Mr.
Greenspan was puzzled by long-term Treasury yields that were
ticking lower despite increases in the federal-funds target
rate.
"I think it's part of the same conundrum, maybe just a
bond-market conundrum redux," said Michael Collins, senior
portfolio manager at PGIM Fixed Income.
Resolving that quandary is key to investors and Fed policy
makers because of concerns the central bank's moves to normalize
interest rates could dent the economic expansion, already the third
longest in U.S. history. Some worry it could also affect
asset-allocation strategies at a time when many are concerned that
stock valuations could be stretched.
If low interest rates push investors into excessive risk-taking,
the Fed may need to tighten monetary policy more drastically, a
scenario that could cause a sharp pullback in stocks and other
riskier assets and raise the threat of a U.S. recession, some
investors said.
Recently, Eric Rosengren, president of the Federal Reserve Bank
of Boston, said that the era of low rates in the U.S. and elsewhere
poses financial-stability risks. And Fed Vice Chairman Stanley
Fischer said the world "cannot afford another pair of crises of the
magnitude of the Great Recession and the global financial
crisis."
Fed officials don't want to see a sharp rise in bond yields
either, some analysts said. The 10-year Treasury yield is a
benchmark for global finance, so a big rise would push up long-term
borrowing costs for consumers and businesses and tighten financial
conditions sharply, a scenario central bankers are trying to avoid,
several said.
The Fed's conundrum is partly a result of investors' confusion
about how to respond to the central bank's plans, which also
include paring back its large balance sheet later this year.
Yields have risen on short-term government debt, which is more
sensitive to the central bank's policy outlook. But yields on
long-term debt are influenced by a variety of factors, including
the economic and inflation outlook in both the U.S. and abroad.
In previous tightening cycles, a popular trade was to sell
short-term debt and put money into long-term bonds, betting on the
gap between the two yields to fall, which is known as a flattening
yield curve. The 10-year Treasury's premium relative to the
two-year note is trading near the lowest level since 2007.
But some investors are concerned that this trade may be getting
crowded and could be vulnerable to a reversal if the Fed surprises
investors with an aggressive approach in unwinding its balance
sheet.
That balance-sheet reduction could push up the term premium for
the 10-year note, say some analysts and investors. The term premium
is the extra compensation investors demand to hold the 10-year
Treasury note instead of buying a series of shorter-term debt over
the next 10 years.
The premium has fallen below zero since March, a sign of
heightened demand for the 10-year note. The premium traded at
around negative 0.4% on June 23, according to the latest data from
the New York Fed's website, near a record low of negative 0.77% in
July 2016, when the 10-year yield closed at a record low of
1.366%.
Some money managers said the Fed's slow and cautious approach
could reduce the chances of a repeat of the 2013 "taper tantrum,"
when the bond market was spooked by then Fed Chairman Ben
Bernanke's comment in May 2013 over a possible cut in bond
purchases.
Several said they planned to wait for the actual implementation
of the Fed's balance-sheet reduction before making wagers on the
yield curve.
"The old playbook may not work," said Jason Evans, co-founder of
hedge fund NineAlpha Capital LP.
Write to Min Zeng at min.zeng@wsj.com
(END) Dow Jones Newswires
June 27, 2017 19:25 ET (23:25 GMT)
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