Supply fears start to hit Treasuries
By Michael Mackenzie in New York and David Oakley in London
Published: March 26 2010 19:18 | Last updated: March 26 2010 19:18
The bond vigilantes are finally flexing their muscles. A long period of stability for the US government bond market showed signs of cracking this week as a lack of investor appetite for new debt sent the benchmark 10-year yield to its highest level since last June.
For more than a year, analysts have been warning that record sized debt sales by the US Treasury were at odds with a 10-year yield sitting comfortably below 4 per cent. This week, the yield on 10-year notes jumped from 3.65 per cent to a peak of 3.92 per cent on Thursday. On Friday it was 3.87 per cent.
Falling inflation, rising unemployment, the housing market slump, the Federal Reserve’s policies of a near zero overnight borrowing rate and its purchase of up to $1,700bn in bonds have all helped keep Treasury yields near historic lows.
But this week the mood shifted as yields for $118bn of new US debt were much higher than forecast, sparking overall selling of Treasuries. Sentiment also deteriorated in the UK bond market after the government’s budget ahead of a general election expected in May failed to resolve doubts over future spending and debt reduction.
The term “bond vigilantes” was coined in the 1980s when bond investors pushed up long-term yields to force central banks into taking action to curb inflation. This time, bond investors are less worried about inflation: they are fretting about huge fiscal deficits and the looming bond supply needed to finance them.
“Everyone thought we would see rising rates due to higher inflation, but it appears the bond vigilantes are demanding a higher real rate due to concerns about Treasury issuance,” says George Goncalves, head of fixed income strategy at Nomura Securities.
Worries about the debt loads of developed economies have come into focus this year amid the crisis threatening Greece and other members of the eurozone periphery.
The fact that German Bunds have outperformed both Treasuries and gilts in recent months highlights this increasing worry over public debt. Germany’s budget deficit is much lower than the US and UK and inflation there is also expected to remain low.
“The spotlight on Greece only helped to reveal that the US’s kitchen – with Federal and state budget balances – was itself full of cockroaches,” says William O’Donnell, strategist at RBS Securities.
It hasn’t helped that the US announced a big overhaul of its healthcare system this month, adding to worries about the scale of US spending.
Moreover, the Fed completes its bond buying programme next week, leaving the market to absorb the supply of new debt on its own. Next week’s March employment report, which economists say could see 150,000 jobs created, also looms as a test for bond market sentiment.
“The environment for debt auctions has turned negative,” says Rick Klingman, managing director at BNP Paribas. “Long-term rates are rising and it is no coincidence that this has occurred after the passage of healthcare reform and the end of Fed buy-backs.”
Also rattling US investors this week was a report by the Congressional Budget Office that falling payroll taxes due to high unemployment, means that the social security programme will pay out more in benefits than it receives for this fiscal year. “A sustained rise in yields is upon us and bond funds will start to incur losses,” says Jim Caron, global head of interest rate strategy at Morgan Stanley. He expects 10-year yields to reach 4.50 per cent in the second quarter, as investors pull their money from bond funds. March looms as the first month for negative returns for investors in Treasuries this year.
For now, other key markets such as equities and the dollar have not been affected by the rise in yields, but that may change if the 10-year rises decisively above 4 per cent and big auctions next month are also poorly received. “This appears as a credit shot across the Treasury market bow and concerns over the US fiscal spending could well move to the dollar and equities,” says Mr Goncalves.
A sign of the strains across US fixed income markets was this week’s historic rupture between the 10-year Treasury yield and its close derivative, the interest rate swap.
For the first time since swaps emerged in the mid-1980s, the 10-year swap rate traded below that of the “risk free” 10-year Treasury yield. Analysts say this reflects how government debt issuance has altered the dynamics between “risk-free” yields and swaps, which reflect borrowing costs for non-sovereign borrowers.
In the UK, swap rates have been below those of 10-year gilt yields since January. The yield on 10-year gilts was at 4.03 per cent on Friday, up from a low of 3.91 per cent earlier this week. The peak yield so far this year was 4.27 per cent in February. In Europe, however, swap rates are 20 basis points higher than 10-year yields.
“If we get clarity on what the UK will do on deficit reduction once the election is behind us, then the market and gilt yields could stabilise,” says Mike Amey, UK portfolio manager for Pimco.
Since the UK budget on Wednesday, the negative spread, or inversion, has widened with swap rates trading nearly 20 basis points below gilts for 10-year maturities compared with a negative spread of 10bps just before the government statement on public finances.
In other words, huge issuance is already creating unexpected distortions and stresses in the market. It is far from clear that we have seen the last of them, given the amounts that still need to be raised.