Bond investors lose faith in Fed guidance

Bond investors are losing confidence in the Federal Reserve’s pledge to keep benchmark interest rates at about zero into 2015 as the U.S. economy accelerates.
Concern that the Fed will increase its target rate for overnight loans between banks next year is showing up in wider price swings for shorter-term securities. Volatility in five-year Treasuries has risen above 10-year notes for the first time since 2011, and yields on two-year notes have more than doubled in the past four months. As recently as last week, Bill Gross, who manages the world’s biggest bond fund at Pacific Investment Management Co. LLC, was recommending debt with short maturities.
While speculation that the Fed will reduce its $85 billion of monthly bond purchases as soon as this week has left bond investors with the worst losses since 1994, JPMorgan Chase & Co. financial models show that the end to the central bank’s zero-rate policy would have an even bigger impact. Policymakers cut rates to records as the financial crisis mounted in 2008 and vowed to keep them there until the economy and employment shows sustained signs of recovery.
“There’s a bit of a discomfort level being priced into the market,” Erik Schiller, a principal and senior portfolio manager at Prudential Financial Inc., which oversees more than $1 trillion, said in a Sept. 10 telephone interview. “Asset purchases have been an emergency measure and we are beyond the need for those measures, and the Fed will try to get more toward traditional policy.”
U.S. bonds rallied Monday after former Treasury Secretary Lawrence Summers quit the race to head the Fed. Summers would have kept monetary policy tighter than Fed Vice Chairman Janet Yellen, who is being considered for the post, according to a Bloomberg Global Poll.
The yield on U.S. 10-year notes fell 8 basis point to 2.81%. The price of the benchmark 2.5% note due August 2023 increased 21/32, or $6.56 per $1,000 face amount, to 97 11/32, according to Bloomberg Bond Trader prices. Five-year yields slipped 11 basis points to 1.59%.
Treasuries have plunged 3.6%, the most in nine years, since Fed Chairman Ben. S. Bernanke said May 22 in congressional testimony that policymakers could “step down” the pace of asset purchases if the employment outlook shows sustained improvement. Yields for 10-year notes touched 3% on Sept. 6, the highest level since July 2011.

Bond Rout

Policymakers will decide at a two-day meeting starting tomorrow to reduce monthly purchases of Treasuries to $35 billion, from $45 billion, according to the median of 34 responses in a Bloomberg News survey of economists. The Federal Open Market Committee will maintain mortgage bond buying at $40 billion, the survey showed.
Treasury 10-year notes gained last week as data showed U.S. retail sales rose less than forecast and consumer confidence fell to a five-month low.
At 1.59%, yields on five-year securities compare with the low this year of 0.64% on May 1 and a high of 1.86% on Sept. 6. Two-year Treasuries yielded 0.38% after touching 0.53% on Sept. 6, the highest level since 2011 and up from as low as 0.19% on May 3.
Ten-year yields will rise to 3.1% and the two-year note will be at 0.6% by mid-2014, according to median forecasts of 60 strategists surveyed by Bloomberg.
“The rise in short-term rates we saw earlier this month was the market pricing in a higher chance of the Fed tightening policy before late 2015,” Alex Roever, the head of U.S. interest rate strategy at JPMorgan in Chicago, said in a Sept. 9 interview.
Futures traders were pricing in a 62.9% probability last week that the Fed will raise rates by January 2015. On May 1, that chance was 17.8%.
JPMorgan’s model shows that the end of all Fed bond buying would lift 10-year note yields by 25 basis points, which the firm says is already priced into the market. If the Fed’s forward guidance were ended, meaning the timing of the first benchmark rate increase were moved forward to today, it would lift yields by 45 basis points, the model indicates.
“Markets have been fixated on the timing of the tapering of bond purchases, but since the June Federal Open Market Committee meeting, movements in yield volatility show evidence that the efficacy of forward guidance has been declining,” Brian Smedley, an interest rate strategist at Bank of America Corp., said in a Sept. 6 telephone interview.
For the first time since July 2011, one option measure of the perceived degree of future changes in swap rates, known as normalized volatility, shows that traders are pricing in greater fluctuations in five-year rates relative to 10-year yields. Movements in swap rates typically mirror trends in Treasuries.
The ratio of normalized volatility on three-month options, known as swaptions, for five-year interest rate swaps relative to similar contracts on 10-year swaps reached 1.03 on Sept. 5, from a low this year of 0.57 in May.
In these deals, two parties agree to exchange fixed for variable-rate interest payments based on a benchmark index such as the London interbank offered rate over a set period. The higher the number, the greater the volatility.

Gross Recommendation

Given the Fed’s guidance on the future path of interest rates and low volatility, one of the favorite trades among investors has been to buy five-year notes and hold them until they had two years or less left or maturity. Even with rates so low, investors would earn profits as yields fell over time to match current maturities and bond prices rose.
Mr. Gross, who runs the world’s biggest bond fund, the $251 billion Total Return Fund, reiterated this month on his website advice from February that investors should buy five- year Treasuries. The difference between five- and 30-year yields may increase by 10 basis points, Gross wrote on Twitter after Mr. Summers announced his withdrawal.
Treasuries due in five years have lost 3.2% in 2013, the most since 1994, Bank of America Merrill Lynch index data show.
Traders have increased bets to the most since 2008 that the securities will continue to fall. Hedge fund managers and other large speculators boosted their net-short position in five-year note futures in the one-week period ended Sept. 10 to 128,756 contracts, according to Commodity Futures Trading Commission data.
Mr. Gross has seen his Total Return Fund lose more than $41 billion, or 14% of its assets, during the past four months through losses and investor withdrawals, according to Morningstar Inc. Mark Porterfield, a spokesman for Pimco, didn’t respond to requests for comment.
Five years after Lehman Brothers Holdings Inc.’s bankruptcy filing Sept. 15, 2008, intensified the worst financial crisis since the Great Depression, gross domestic product is forecasted to expand 2.7% next year, according to a Bloomberg survey, the fastest rate since 2006. The unemployment rate fell last month to 7.3%, from 7.8% in December.
The Fed, which has kept its benchmark overnight bank lending rate in a range of 0% to 0.25% since 2008, said in December it will maintain that rate while unemployment holds above 6.5% and inflation stays below 2.5%.
The rise in short-term yields “could reflect to some extent expectation that the unemployment rate is going to get to 6.5% before the Fed expects and that therefore, the rate hikes are going to start sooner than the Fed anticipates,” Alan Levenson, chief economist in Baltimore at T. Rowe Price Associates Inc. said Sept. 11 in a telephone interview. The firm oversees about $614 billion.
Investors may also have been anticipating changes in Fed policy when Mr. Bernanke steps down in January.
The market reflects “leadership uncertainty at the Fed,” Mr. Schiller said before the announcement by Mr. Summers.
Bond investors globally have been demanding higher yields on shorter-term developed-nation government debt amid speculation that their central banks won’t fulfill pledges to keep down rates as growth quickens.
Average yields on developed-market debt due in three years or less are the highest since 2011, rising to 0.51% on Sept. 5, according to the Bank of America Merrill Lynch 1-3 Year G7 Government Index.
“Forward guidance is an attractive concept, but what the market is looking at is the economic data at the moment, and that’s looking a little bit better,” Craig Veysey, the London- based head of fixed income at Sanlam Private Investments Ltd., which manages more than $10 billion, said in a Aug. 29 telephone interview. “The market wants to look at pricing in interest rate changes sooner than the forward guidance would suggest.”