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The bond vigilantes are back again.
That group, defined as investors who protest U.S. fiscal policies by selling bonds, keeps demanding more term premium, or compensation, to hold government securities to maturity, according to Ben Emons, senior portfolio manager and head of fixed income for NewEdge Wealth LLC in New York. For now, that’s been overwhelming any buying interest from other investors searching for yield.
Emons points out that the 10-year Treasury yield
BX:TMUBMUSD10Y,
which touched an intraday high of almost 4.965% on Wednesday amid a renewed selloff in U.S. government bonds, is moving rapidly toward its forward yield of 5.75%. That forward yield, as shown on Bloomberg, reflects where traders expect the 10-year yield to be five or 10 years from now, and “is not an unrealistic” level which could be reached in the near future, Emons said via phone.
Treasury yields are simply returning to historically normal-looking levels, but the speed with which they’re getting there poses risks to financial markets and the U.S. economy. One reason is that corporations, used to borrowing at low rates in the past, would be forced to absorb higher interest rates when they refinance and to likely trim costs elsewhere.
Joseph Kalish, chief global macro strategist with Ned Davis Research in Sarasota, Fla., has identified a 10-year Treasury yield that rises above 5.25% as one risk that could lead to something breaking in the economy, financial markets or both because that level marks the “important double-top” reached in 2006-07 and the peak Federal Reserve policy rate of that cycle.
Read: The 10-year Treasury yield briefly pierced 5%. Here’s what could drive it higher.
Source: U.S. Treasury, Bloomberg.
Meanwhile, the term premium — or theoretical level that encapsulates all of the risks that investors want to be compensated for — just keeps rising, based on estimates from the New York Fed. That premium, which is hard to quantify, includes everything from the U.S. fiscal outlook and a potentially unending supply of Treasurys to inflation, stronger economic growth, and higher-for-longer rates. It’s jumped alongside the amount of Treasury bills being issued as a percentage of outstanding government debt, according to Emons.
Source: U.S. Treasury, New York Fed.
Wednesday’s selloff is helping to reverse the impact of Monday’s session, when buying prevailed after a pair of big-name investors questioned the continued strength of the U.S. economy. Bill Gross, co-founder of fixed-income investing giant Pacific Investment Management Co., said the economy is likely to be heading for a recession by year-end, while Pershing Square’s Bill Ackman said he has closed his bet against 30-year Treasury bonds
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and that the “economy is slowing faster than recent data suggests.”
“What we saw on Monday was a knee-jerk reaction to Ackman and Gross, it was a brief covering of shorts,” Emons of NewEdge Wealth said. “But that’s not enough to actually reverse the rise in rates based on strong economic data and more borrowing by Treasury. It would truly change if we had people in Congress say, ‘This is it, we will cut spending,’ but we are not there yet.”
Wednesday’s resumed Treasurys selloff took place against a backdrop in which Washington is trying to bounce back from dysfunction. The Republican-led U.S. House of Representatives finally managed to elect a new speaker, Rep. Mike Johnson of Louisiana, on Wednesday after a chaotic three-week period in which it was without a leader.
As of Wednesday afternoon, rates on everything from 1-year Treasury bills to the 30-year bond were all higher, led by advances in intermediate- and long-term yields. Meanwhile, all three major U.S. stock indexes
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were down, led by a 2.4% drop in the Nasdaq Composite.
One of the technical factors driving the ongoing selling of longer-term government debt right now is the need of mortgage-linked servicers and portfolio managers to manage their risks and exposures to interest rates on mortgage-backed securities, according to Emons.
For now, MBS is “positively convex” — meaning that each time long-term yields rise, the price on mortgage-backed securities declines, which can make the bond market prone to wilder swings. That also can trigger more selling by mortgage-linked players, and positive convexity may be enough to push the 10-year rate to 5.5% at some point, he said.
Whether a 5.25%-5.75% 10-year Treasury yield would be enough to break the economy “depends on when companies have to refinance maturing debt. That could really impact the economy because a lot of companies would look at cost-cutting and layoffs,” Emons said.
In determining what might cause damage in financial markets, he said that “it’s more about whether leverage in the system is going to be unwound, and that’s hard to estimate. If I were to point to something that could break, unwinding of leverage by hedge funds would be one way that could happen” and it could be “multiple hedge funds” involved “because interest paid on that leverage is getting too high.”
