After Treasuries’ Steep Losses, Is the Sell-Off Nearing an End?
When bond-market players return to their trading desks this morning, their ears may still be ringing from last week’s donnybrook.
Pushed and pulled by conflicting economic data, havoc in the mortgage market and more disappointment over a perceived Federal Reserve policy flip-flop, Treasury bonds suffered their sixth loss in seven weeks.
“It’s been kind of scary,” said Brian Edmonds, head of Treasury trading at Banc of America Securities, speaking amid the din of traders yelling on Friday.
Indeed, the sell-off in Treasuries since mid-June has been one for the record books, and has driven yields on longer-term securities to one-year highs. (Yields move in the opposite direction of bond prices.)
The yield on the benchmark 10-year T-note, which had sunk to a 45-year low of 3.11% in mid-June, zoomed as high as 4.59% Friday before pulling back to close at 4.38%.
But the fallout from the Treasury market’s woes so far has been limited in some other key markets. Yields on corporate “junk” bonds, for example, have risen only modestly since mid-June. And the stock market, though down last week, is off just slightly from its recent peaks.
For Treasury owners, the losses have become epic. In terms of total return -- interest earnings plus or minus a change in market value -- the 30-year T-bond lost 11% in July and the 10-year note lost 7% -- respectively the worst and second-worst one-month losses ever, according to John Kosar, senior research analyst at Bianco Research in Chicago.
Yet, for all the tumult, nothing has been settled.
Fundamentally, it isn’t clear whether the economy is blasting out of its doldrums, which could send interest rates still higher, or whether the recovery will fizzle should consumers stop spending and businesses keep the clamps on hiring.
In the view of some bond pros, one of the Treasury market’s biggest problems has been that both the rosy economic scenario, and the bleak one, were embraced within the space of about 10 weeks by the same oracle: Federal Reserve Chairman Alan Greenspan.
“I think the Fed made a colossal blunder,” said David Brownlee, bond portfolio manager for National Life Investment Management Co. in Montpelier, Vt.
In early May, Greenspan hinted that the Fed was worried enough about the economy to prepare unusual policy measures. The bond market took that to mean that the Fed might inject cash into the economy by directly buying Treasury securities, which would boost bond prices and drive long-term yields lower, Brownlee said.
That pronouncement triggered a buying frenzy in Treasuries from mid-May to mid-June.
Brownlee and other bond watchers said that the 10-year T-note never should have gotten near 3%. It was clearly an overreaction, they say, and left the market primed for a snap-back.
Fueled in part by some upbeat economic data, by early July the T-note was back at its early-May level of 3.65%.
However, in Brownlee’s view, Greenspan helped turn an orderly retreat into a rout on July 15 when he implied during testimony to Congress that the Fed was ruling out any special measures such as bond purchases. That same day, a report from the Fed anticipated robust economic growth of 3.75% to 4.75% next year.
Treasury yields rocketed on that news, and their upward momentum has mostly continued since, even as economic data have remained mixed -- witness Friday’s report that the economy lost jobs in July.
It’s natural for the Treasury market to respond to economic fundamentals, but experts said the extremes of volatility this summer have been exacerbated by mortgage-bond investors who use Treasuries to hedge their portfolio positions.
The nation’s amazing home-refinancing boom has run into a stone wall in recent weeks as mortgage rates have been pushed up with yields on long-term Treasuries. The plunge in refinancings has extended the so-called duration of mortgage-backed bonds, meaning that investors won’t get their money back as soon as they thought.
That has sent mortgage investors scrambling to hedge their bets in a tactic called the “mortgage convexity trade,” which requires them to sell Treasury securities, pounding that market down even further.
In years past, a sudden upturn in mortgage rates wouldn’t have roiled the Treasury market much. However, as CS First Boston bond strategist Michael Cloherty puts it, mortgages have become the 800-pound gorilla of the bond market, as home sales have soared since the mid-1990s and more home loans have been bundled and sold as mortgage-backed securities.
In 1990, there was $2.2 trillion in Treasuries outstanding, compared with $1.3 trillion in mortgage-backed bonds, Cloherty said. Today, while the Treasury market has grown to $3.3 trillion, mortgage bonds have exploded to $4.9 trillion.
For bond fund managers, “If you’re overweight mortgages, you’ve got to buy [Treasuries] when the market rallies and sell when it dives, so you exaggerate any movement,” Cloherty said.
How sharp have the moves been? Bianco Research’s Kosar likes to use the Treasury-bond futures market as a gauge. Last Thursday, he said, 561,863 futures contracts were sold, extraordinary volume for a day that wasn’t part of a quarterly rollover period, when investors routinely sell and buy back to maintain their positions.
In fact, said Kosar, it was the heaviest volume for a non-rollover period since early 2000, when bond yields began to plunge. And the price range of the contract Thursday marked the greatest volatility in the history of the security, dating to 1977, he said.
“I used to work on the floor of the Chicago [Mercantile Exchange], and on days like this, you experience the volume,” Kosar said. “It’s literally like a John Wayne movie where people are flying around like crazy. There’s so much money changing hands that there are a lot of big winners and losers.”
In Kosar’s experience, such huge trading days tend to represent market “blowoffs,” dates that you can circle on your calendar and look back on later as moments when the market made an important change in direction.
So perhaps Thursday will turn out to have been the bottom of the midsummer collapse in bond prices and the market will rally from here, Kosar said.
Dana Johnson, research chief at Banc One Capital Markets in Chicago, agreed that the Treasury market was due for a rally, but he wasn’t ready to bet on it yet. “I think it’s overshot,” he said, “but I’m not sure it’s done overshooting.”
This week, the market faces an onslaught of new bonds, as the Treasury sells a total of $60 billion in three-year, five-year and 10-year notes to finance the ballooning deficit. The sales begin Tuesday.
While the situation has been dismal for Treasury owners, investors who hold corporate junk (non-investment-grade) bonds have seen the value of their securities hold up relatively well. The yield on the KDP Investment Advisors index of 100 junk issues, at 9.01% Friday, is just back to where it was in early June.
Although rising Treasury yields eventually can make junk-bond rates look too low by comparison, an economic rebound improves companies’ financial prospects and thus their ability to make bond payments, boosting security for high-yield investors, experts say.
Likewise, a stronger economy should mean healthier corporate earnings. That hope has so far supported the stock market, despite higher interest rates. The Standard & Poor’s 500 index lost 1.9% last week, but at 980.15 on Friday it’s down less than 1% from its level on June 13, when Treasury yields bottomed.
