The US Treasury market has been experiencing volatility in recent days and weeks. The US Federal Reserve (“Fed”) announced in May that it may begin reducing quantitative easing, triggering months of losses in US government debt.
Prices have been falling, with the benchmark 10-year yield notably hitting three per cent last week – the highest level in two years. Following the relatively weaker-than-expected US jobs report on Friday, the yield retreated slightly.
Back in May, the Fed indicated that it may begin tapering the US$85 billion-a-month bond buying programme and reduce its purchases of US government and mortgage bonds.
Encouraging economic data released in recent months continued to boost the perception among investors that the US central bank will in fact be in a position to scale down its extraordinary monetary stimulus soon.
The expectation of a lower level of support for US bonds resulted in a sell-off of these assets – US government debt lost about four per cent so far this year according to Bank of America Merrill Lynch indexes. This trend is clearly reflected in the US benchmark 10-year yield, which has risen by more than 100 basis points since the Fed’s tapering comment, to around 2.95 per cent.
The movement in US Treasury bond prices and benchmark yields has broad significance and potential implications. The underlying trigger for the rise in US yields, an improving US economy, is a positive development.
The movement in US Treasury bond prices and benchmark yields has broad significance and potential implications
However, if market yields continue to spiral upwards, at some point the Fed may be perceived by investors to be unable to keep the lid on rates, or to scale back its extraordinary stimulus in an orderly manner. This, in turn, could result in further losses. Analysts often refer to 1994, when fears of rate rises drove investors to dump US government bonds aggressively, overshooting prices and amplifying volatility.
Several US bond funds have already been reporting growing levels of outflows. Pimco’s Total Return Fund, considered the world’s largest mutual fund, lost more than US$41 billion in losses and outflows during the past four months, including US$8 billion of redemptions in August alone, according to researcher Morningstar. International investors have also been observed to be reducing their exposure to US government debt. According to data released by the US Treasury department in August, China and Japan were major sellers of US Treasuries in June, accounting for around US$40 billion of net outflows.
A rapid or unrestrained rise in yields could also impact the real economy in the US, by damaging the nascent recovery. The most recent Beige Book (report on US economic conditions published by the Fed), while overall moderately positive, showed that there was a reduction in mortgage re-financings caused by the recent spike in mortgage rates.
Beyond the US, government bonds of other countries have also been impacted by movements in US market yields. The German 10-year Bund is trading at a yield of around two per cent compared to 1.2 per cent in early May – this is the highest level since the first quarter of 2012.
While there have been some very tentative signs of modest improvement in the euro economy, the recovery is behind that of the US. Therefore a rise in yields would seem premature. Partly as a reaction of this trend, ECB President Mario Draghi, noted that the ECB’s policy “will stay accommodative for the foreseeable future”.
Emerging markets have been a notable victim of the shift in sentiment relating to US monetary policy and of the rise in benchmark yields. With expectations growing that we are approaching the end of ultra-cheap money across global financial markets, investors have generally shunned emerging markets assets.
Credit spreads are wider, equity indices have declined, and currencies have devalued for a wide range of developing economies. For example, the sovereign five-year Credit Default Swap (or “CDS” contract), which measures credit risk perception, has basically doubled for Turkey since early May; for Brazil the CDS has surged by more than 70 per cent. The Turkish lira and Brazilian real have both devalued by around 14 per cent during the same period.
This aspect of recent market trends is being given considerable importance. Last weekend, IMF managing director, Christine Lagarde, indicated that it would be sensible for policy makers of developed nations to keep in mind the impact on emerging markets of ending loose monetary policies.
As investors now look to the Fed’s possibly crucial policy meeting to be held next week, the hope is that an orderly withdrawal of the exceptional monetary stimulus may be achieved.
This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Any opinions that may be expressed here above should not be interpreted as investment advice, nor should they be considered as an offer to sell or buy an investment. The company and/or the author may hold positions in any securities that might have been mentioned in this report. The value of investments may fall as well as rise and past performance is no guarantee of future performance.
Curmi & Partners Ltd are members of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business.
Karl Falzon is a credit analyst at Curmi and Partners Ltd.