U.S. Treasury Market Goes OFF Script

The crosscurrents roiling the bond market intensified Thursday, as the gap between short- and long-term U.S. Treasury yields narrowed in the latest sign of uncertainty over the pace of U.S. growth.

Yields on short-term U.S. Treasury debt maturing in two to five years hit the highest level since 2011, reflecting an investor scramble to place bets on an expected Federal Reserve rate increase as soon as next spring. Yields rise when prices fall.

The selloff in short-term government debt extended a pullback that began following Wednesday’s Federal Reserve decision to end its bond purchases later this year.

At the same time, yields on government debt maturing in 10 or more years have risen only modestly this week and remain well below their levels at the start of 2014, a year that many analysts forecast would include rising long-term interest rates and falling bond prices. The 10-year U.S. Treasury note was 8/32 lower, yielding 2.629%. That is the highest closing level since July 3 but compares with 3% at the end of 2013.

The softness of longer-term yields highlights concerns shared by many analysts and policy makers about the uneven growth of the U.S. economy and falling expectations for inflation. Investors broadly expect the Fed to raise the fed funds rate next year for the first time since 2006. But many analysts say that even a small uptick in rates could slow the economy and send already-low inflation further below the Fed’s target.

“The bottom line is that the bond market continues to signal that the Fed can pursue its normalization of interest rates, but that when it does so, it will constrain growth and lower inflation to the point that they fail on their mandate and damage the recovery process,” said Richard Gilhooly, senior U.S. rates strategist at TD Securities in New York.

Rising short-term rates typically are accompanied by higher long-term rates in a robustly growing economy. The recent shift of U.S. short- and long-term yields underscores uncertainty over the outlook.

Low inflation for a sustained period could raise fears of deflation, a damaging cycle in which falling prices discourage consumers and businesses from spending. Few analysts are concerned now about the prospect of deflation in the U.S., but Japan has struggled with deflation for more than a decade and European policy makers are considering actions to prevent falling-price expectations from taking hold.

The bond-market conundrum came as stock investors continued to applaud the Fed’s steady-as-she-goes message. The Dow Jones Industrial Average gained 109.14 points, or 0.6%, to 17265.99 and the S&P 500 index rose 9.79 points, or 0.5%, to 2011.36. Both indexes closed at fresh records. The Nasdaq Composite Index added 31.24 points, or 0.7%, to 4593.43.

The Fed said, in its Wednesday statement, short-term interest rates would remain near zero for a “considerable time” after the end of its monthly bond purchases. Fed Chairwoman Janet Yellen declined to elaborate on how much time that meant.

In a nod to the pullback in consumer prices lately, the Federal Open Market Committee said in a statement Wednesday that “inflation has been running below the Committee’s longer-run objective.” In July, the FOMC had taken a more-upbeat stance, saying inflation “has moved somewhat closer to the Committee’s longer-run objective.”

In late-afternoon trading, the two-year note was 1/32 lower, yielding 0.569%. The yield settled at the highest level since May 2011.

Yields on shorter-dated notes are sensitive to changes in the Fed’s interest-rate outlook, while yields on longer-dated bonds are more influenced by inflation.

Thursday’s upbeat labor-market report further added to anxiety. Initial claims for unemployment benefits posted the largest drop in nearly two years.

Trading volume on derivatives betting on the Fed’s interest-rate outlook has hit a record high. There were 6,880,382 euro-dollar contracts traded Wednesday, exceeding the previous record of 6,039,753 contracts on March 19, according to data from CME Group.

“The Federal Reserve is removing the punch bowl, and it is time to be defensive” in your bond portfolio, said David Kotok, chairman and chief investment officer of Cumberland Advisors in Sarasota, Fla., which manages $2.25 billion in assets. “The bond market needs to adjust, which means higher yields.”

Another attraction to buying long-term U.S. bonds is they offer superior yields compared with government bonds in Germany and Japan. Traders said this will continue to draw foreign investors seeking relative value. A rising dollar adds to the allure of buying U.S. bonds.

Grant Peterkin, senior portfolio manager in fixed income at Lombard Odier Investment Managers, which oversees $47.7 billion, said it is “still possible” the 10-year yield could rise to 3% at the end of this year.


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