In the world of spiralling US bond yields, all eyes on Thursday will be on the upcoming auction of 30-year long bonds following the Treasury’s sale on Wednesday of 10-year notes which saw bond yields hit their highest level this year.
The benchmark 10-year Treasury note hit 4 per cent at one stage on Wednesday – for the first time in eight months – after the government bond auction sparked fears that the cost of financing record levels of US debt could threaten the economic recovery.
As the FT reports on Thursday, the US Treasury was forced to offer yields of up to 3.99 per cent on the $19bn auction of 10-year bonds to lure investors, a much higher level than expected by markets.
The auction was one of many offerings this week aimed at raising $65bn, and is being followed with Thursday’s sale of about $11bn of 30-year securities.
Basically, investors are increasingly worried that rising bond yields could stall the fragile economic revival as they force up the cost of mortgages and lending to companies. As the FT notes, the US government may borrow $3,250bn in the fiscal year ending September 30, almost four times the $892bn in 2008. Not only that, the US budget deficit is projected to increase to $1,850bn this year.
In the process, however, bonds could become an appealing investment prospect – if yields keep rising the way they have been.
As 24/7 remarks on Wednesday:
If rates hit 5% on that Long Bond or get much higher than 4% for that 10-Year Note, then it is likely that the money that has been chasing stocks for gains may decide to jump over to the safety of assured yields at higher rates than have been seen in months and months.
You never know what the exact hurdle is that starts to lure investors off of the sidelines or out of stocks for the ultimate safety net of US Treasury notes and bonds, 24/7 continues. But in theory this happens at each full percentage point for long-dated Treasury yields:
With a trade deficit continuance, with a fresh record May budget deficit, a questionable dollar, and the fears of future inflation coming on strong, you have to wonder if we have yet to see the real peak in long-term bond yields. As the FOMC has yet to even signal any formal rate-change or any real policy change to the lower-end of the curve staying low, it seems hard to imagine that we have seen the highest rates in longer-dated Treasury bonds. All of this will become critical for the 30-Year Bond auction on Thursday.
So what specifically lies behind the recent surge in bond yields? Hong Kong-based investment and research house Gavekal notes in its daily client newsletter that the rise in yields was a key factor in the weakness of the S&P 500 on Wednesday, as it lost 0.40 per cent despite a very strong day on Asian markets and a decent day in Europe.
The recent spike in long-dated bond yields raises a number of worriesome questions, in Gavekal’s view:
Will financing costs on the government’s massive debt load surge? Will rising financing costs for the private sector derail the nascent recovery? Are foreign governments finally abandoning the US debt market, as we have been repeatedly warned would one day happen?
However, the trend should be seen as yet another sign that markets are normalising. Looking at Wednesday’s auction, it notes:
- Demand remains high. The bid-to-cover ratio was 2.62x, higher than last month’s 2.47x and, according to Bloomberg, above the 2.4x average of the past ten sales.
- Foreign central banks are still buying. Indirect bidders bought 34 per cent of the notes, up from 32 per cent bought in May and above the 26% average at the past ten auctions. As the “indirect bidders” category includes foreign central banks, this indicates increased buying from these parties, a theory backed by data showing that despite the rhetoric, foreign central banks increased their holdings of US$ Treasuries by $75bn in the four weeks to June 5 (and this is only counting the Treasuries held through the Fed—see the Council of Foreign Relations analysis of the latest Fed custodial holdings data here).
- Diversification out of the dollar remains minimal. China, Russia and Brazil have said they would be happy to put up a combined $110bn in a planned IMF bond issuance. However while the IMF is seeking $750bn in new funding to help deal with the crisis, it is likely to issue from $250bn to $500bn in bonds. In comparison, the US has issued US$1.5trn in Treasuries issued in the past year alone. China, Russia and Brazil together have a combined $2.5 trillion in forex reserves—where is this money supposed to go? Clearly, foreign central banks with large reserves will have a hard time extracting themselves from the Treasury market, unless they choose the currency appreciation route.
While investors may be demanding higher yields for their US bonds, there is slim evidence of an impending buyers’ strike, he notes. But will this normalisation in bond yields stall economic recovery? Historical trends – though the severity of this financial crisis means they may not be completely applicable – offer some solace, adds Gavekal:…Bond yields generally bounce as recessions end, then eventually trend back down. In recessions that saw the sharpest plunges in yields (such as the current one), we also saw the biggest post-recession jump in yields. Bonds are usually dumped with more vigor when the real yield is one-standard deviation lower than the norm. Currently, real yields are drastically low, indicating the upward trend in yields will continue.But here there are two important points to make: 1) higher yields very rarely derailed past rallies (a counter example is the early 1980s recessions) and 2) debt-to-GDP ratios are at record (non-wartime) highs, so central banks have every incentive to keep rates as low as possible, and thus if they must tighten, they would more likely hack away at fiscal spending than raise financing costs.
Lex, meanwhile, noted on Monday that the epithet “vigilante” evokes a band of righteous souls committed to holding wayward governments to account. Do not, however, confuse activism with omniscience, it says, warning that “fixed income investors are just as likely to be wrong as everyone else over the coming months”.If “vigilantes” really are punishing reckless governments, why have 10-year yields also spiked over 100 basis points since March in Australia, for example, with sound finances and no quantitative easing programme? Lex concludes:It is more likely that, mirroring the equity market, bond investors are drunk on the green shoots and reflation story. Should the economy not recover quickly, with inflation remaining absent, bonds could again rally — with the vigilantes slipping quietly into the night.
Don’t hold your breath.
Related links:
Surge in US bond yields sparks concern – FT
Bond yiels now compete with stocks for investor funds – 24/7