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Bond-Market Tumult puts ‘Lower for Longer’ in the crosshairs

February’s government bond routine has rattled on one of the foundations of last year’s strong stock market rally: investor confidence that ultra-low long-term yields are here to stay.

A surge in sales over the past two weeks drove the return on the 10-year government bond note, which helps put borrowing costs on everything from corporate debt to mortgages to above 1.5%, the highest level since the pandemic began and rose from 0, 7% in October.

A number of Federal Reserve officials have said the rise is healthy, reflecting investors’ improved expectations for a vaccine- and stimulus-driven economic recovery. Many portfolio managers say they believe interest rates are likely to flatten out in the coming days as returns finally reach what they see as attractive levels. These views will get a new test this week, with Fed Chairman Jerome Powell scheduled to appear in public on Thursday and the release of February̵

7;s job report on Friday.

But there are signs, such as an unusually soft demand for recent government debt auctions, that sales may not be over and that dividends may need to rise further. Some traders warn that bond markets are signaling a strong economic recovery that could boost the dynamics that have kept borrowing costs low while keeping stocks up for entry – potentially a recipe for more of the topsy-turvy trading seen in over the past week as the Dow industrial swung more than 1,000 points over three days.

“There is a perception that recovering from a pandemic looks different from a normal recession,” said Michael de Pass, global chief of the U.S. Treasury Department’s trade in Citadel Securities.

Traders said the dynamics were evident in a Treasury auction late last week. Demand for five- and seven-year-old Treasuries was weak Thursday heading into an auction of $ 62 billion. On seven-year notes and almost evaporated in the minutes after the auction, which was one of the worst received that analysts could remember.

The seven-year note was sold at a yield of 1.195% or 0.043 percentage points higher than traders had expected – a record gap for a seven-year note auction, according to Jefferies LLC analysts. Primary dealers, large financial companies that can trade directly with the Fed and are required to bid at auctions, were left with approx. 40% of the new banknotes, about double the recent average.

The lukewarm demand concerned investors because the government is expected to sell a huge amount of debt in the coming months to pay for the stimulus effort behind the recovery. Further poor auction results could lead to further sales in the bond markets and undermine the tone in other markets, such as equities, investors say.

Analysts thought an increased supply of Treasury could weigh on the market towards the year, but “it’s very different when it’s actually dealing with it,” said Blake Gwinn, head of US interest rate strategy at NatWest Markets.

Some traders said that recent moves have been exacerbated by the settlement of popular trades involving buying short-term Treasurys and selling other assets against them. Many highlighted one in particular: holders’ efforts to protect their investments in mortgage bonds against the rise in returns, a practice known in industry parlance as a convexity hedge.

The Fed’s interest rate cuts over the past year helped create a wave of home sales and refinancing, but the recent rise in interest rates drove mortgage rates to their highest level since November last week, and applications have fallen. It forces banks and other holders, such as Real estate mutual funds, to sell Treasurys to offset mortgage losses that occur when consumers stop refinancing.

Movements in market-based measurements of inflation are also a cause for concern. Rising prices dampen purchasing power for fixed-rate bonds and may force the Fed to raise interest rates faster than expected. While inflation has been subdued for years, usually below the Fed’s target of 2%, some are concerned that economic reopening and stimulus from the Fed and Congress could trigger an acceleration.


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The five-year break-even rate – a measure of expected annual inflation over the next five years stemming from the difference between interest rates on five-year Treasuries and the corresponding government inflation-protected securities – has hit 2.4% in recent days, the highest since May 2011.

“The question is whether 2% inflation can be maintained when we reach it,” said Matthew Hornbach, global head of macro strategy at Morgan Stanley..

He said the magnitude of US fiscal stimulus means that inflation “has a very reasonable chance of getting up to 2% and staying there.”

At the same time, the recent rise in government bond yields not only reflects rising inflation expectations, as was significantly the case earlier in the year. Over the past two weeks, returns on government inflation-protected securities – a proxy for so-called real returns – have also shot up, as the 10-year TIPS return rose from approx. minus 1% to minus 0.7%.

This move has caught the attention of investors because many credit deep negative real returns by helping power stocks to record, pushing interest-seeking investors toward more risky assets. Real yields were around zero percent or higher from mid-2013 to early 2020, meaning they may have more room to rise, even after their most recent move.

The yield on the 10-year US government bond settlement settled at 1,459% on Friday, down from 1,513% the day before, but up from 1,344% at the end of the previous week.

Currently, many investors are moving to assets that are less vulnerable to interest rate fluctuations. Stocks are less competitive with bonds as interest rates rise. Shares in some of the most popular technology stocks, including Amazon.com and Apple,

have fallen from their highs in the last month.

Rick Rieder, investment manager for global fixed income at BlackRock Inc., said his team has bought variable rate loans rather than bonds to protect against rising interest rates and take advantage of the economic recovery.

“We rotated a good portion of our high-yield bond yields on loans,” Mr. Rieder said. “Real interest rates have been negative by 1%. They are finally moving, but they still have a little more to go, which will ultimately push interest rates higher than today’s levels. ”

Write to Julia-Ambra Verlaine at Julia.Verlaine@wsj.com and Sam Goldfarb at sam.goldfarb@wsj.com

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