As Bond Yields Rise, Some Investors Fear Another False Dawn

logo-cropped-11Promising signs in the bond market, as yields are heading higher around the world, a move typically linked to rising expectations of economic growth and inflation.

Source: The Wall Street Journal

As the Federal Reserve’s policy-setting committee prepares to meet on Tuesday, one signal suggests that investors believe the economy, and financial markets, may be finding a footing after a tumultuous start to the year.

Government-bond yields are heading higher around the world, a move typically linked to rising expectations of economic growth and inflation. As investors drive down bond prices, yields rise.

But while there is some suggestion that this trend could continue–investors this month had accumulated the most bets in favor of rising yields since November, according to TD Securities–many believe this could be yet another short-lived move.

For some, the worry is that the recent bond selloff is just the latest in a series of false starts. In three of the last four years, bond prices have fallen sharply to start the year, only to surge later as economic and geopolitical concerns took over investors’ minds.

“There is a strong feeling of deja vu in markets right now,” said Jeff Greenberg, macro strategist at UBS Securities. “The similarities in some markets are uncanny.”

The 10-year German government-bond yield hit 0.228% Friday, up from this year’s closing low of 0.089% on April 7. Over the same period, the yield on the U.S. Treasury note has climbed to 1.888% Friday from 1.69%. That partly reverses moves earlier this year, when tumultuous markets sent investors fleeing into the safety of government bonds, pushing their prices up and their yields down.

But by comparison, just last spring, yields on the 10-year German bund hit their lowest-ever close of 0.07% before rebounding in subsequent weeks to 1%.

That rally in yields didn’t last. The experience rattled traders and has many bracing for more volatility ahead.

Few traders expect the Fed to raise interest rates at this week’s meeting, which ends Wednesday, but investors will be watching closely for signs that a rate increase could be on the table at June’s meeting. The Bank of Japan’s policy-making committee meets later in the week.

Last Thursday, European Central Bank President Mario Draghi gave a nod to improving financial conditions amid ultraloose monetary stimulus, which sent German and the U.S. government-bond yields higher. But Mr. Draghi continued to signal that the door remains open to added monetary stimulus, if needed. The ECB is buying €80 billion ($89.8 billion) of bonds a month compared with €60 billion prior to its March meeting.

Also driving yields higher, data released earlier this month showed China’s exports in March increased for the first time in nine months, and renewed strength in its housing market has helped spark a rally in iron-ore and steel prices.

In the U.S., the latest weekly jobless claims fell to the lowest level since 1973, the latest sign of a robust labor market. A gauge of investors’ sentiment on the economic outlook in Germany rose in April to the highest level this year.

Some big investors such as hedge funds are betting yields will keep going up. They held a net $2.4 billion in 10-year Treasury futures contracts that would benefit from lower prices and higher yields in the week ending April 19, according to the latest data from TD Securities.

Such net negative wagers hit a net $11.7 billion in the week ending April 5, the highest since November, according to Cheng Chen, U.S. strategist at TD Securities. Those investors held $5 billion in bets going the other direction in late March.

Investors broadly pulled $279.7 million out of U.S. bond mutual and exchange-traded funds targeting U.S. government bonds for the week ended April 20, according to data from fund tracker Lipper. That was the eighth consecutive weekly outflow, following 11 weeks of net inflow.

In part, the recent move in bonds reflects the natural response to a sharp 2016 rise in bond prices that few analysts predicted.

Yet the higher yields and outflows also reflect a rebounding oil market, Fed promises to move slowly in tightening policy, and receding fear of a sharp slowdown in China, traders said.

Despite the persistent claim that central banks are out of ammunition, this month’s selloff in government bonds “does tell you to a degree that people are buying into the concept that policy measures will eventually work,” said Charlie Diebel, head of rates at Aviva Investors, which had $418 billion assets under management at the end of December.

Inflation expectations have risen modestly, reflecting in part the more-upbeat market sentiment and a steady rise in oil prices. The 10-year break-even rate, reflecting the yield spread between the 10-year Treasury inflation-protected bond and the 10-year Treasury note, reached 1.65 percentage points Friday, the highest level since August.

That suggests investors expect U.S. inflation to run at an annualized 1.65% on average over the next decade. The rate sank below 1.2% in mid-February to the lowest level since 2009.

Richard Gilhooly, head of interest-rate strategy at CIBC World Markets Corp., said that many investors are selling regular Treasurys and buying inflation-protected government bonds in case inflation flares up.

Inflation “has been the slow-moving catalyst that is lifting global bond yields,” Mr. Gilhooly said.

Another sign investors are growing more wary of inflation: The yield premium investors demand to hold the 10-year Treasury note instead of the two-year note increased Friday to 1.07 percentage points, the highest since the end of March. The premium fell below one percentage point on April 7, near the smallest since late 2007. Investors typically demand a higher premium to own longer-term debt when they are concerned that inflation may pick up speed.