Hedge funds have played an instrumental role in this year’s rout in the US bond market by selling off more than $100 billion in Treasurys, according to a Bloomberg report.
Investors in the Cayman Islands, a major financial center and a known domicile for leveraged accounts, have been the biggest net sellers of US government debt, offloading $62 billion of sovereign bonds in February and dumping $49 billion in January, with Bloomberg citing data from the Treasury Department.
The sell-off began after the early January Senate run-off elections that were won by two Democrats. The victories gave that party a 51-vote majority in the upper house of Congress, including Vice President Kamala Harris, paving the way for a large new round of government fiscal spending. In March, President Joe Biden signed into law a $1.9 trillion stimulus package that passed 51-50 in the Senate.
The rollout of COVID-19 vaccines also contributed to investors deciding to exit bonds. As bonds sold off, rising yields prompted a return of convexity-type hedging flows, Bloomberg reported.
The bond market sell-off this year drove the widely watched 10-year Treasury yield above 1.7% for the first time since early 2020. The yield has since pulled back to around 1.58%.
US equities traded mixed on Wednesday as stimulus optimism was offset by rising Treasury yields.
Early strength across stock sectors faded after ADP’s monthly employment report showed February job growth handily missing expectations. The US added 117,000 private payrolls last month, according to the report. Economists surveyed by Bloomberg anticipated a 200,000-payroll gain.
The reading signals the labor market is returning to growth after a nearly stagnant winter, but the weaker-than-expected data highlights just how difficult it will be for the economy to recoup millions of lost jobs.
Treasury yields swung higher soon after the report’s release. The move revived concerns of overstretched stock valuations and saw the tech-heavy Nasdaq composite underperform peers.
Here’s where US indexes stood shortly after the 9:30 a.m. ET open on Wednesday:
The modest decline follows similar weakness in Tuesday’s session. Valuation concerns led tech stocks to weigh on major indices. The Nasdaq composite sank the most, tumbling 1.7% into the close.
ADP’s labor-market data overshadowed new optimism around the nation’s fight against the coronavirus. President Joe Biden announced Tuesday afternoon that the US will have enough vaccine doses for every American by the end of May, pulling forward the key forecast by two months.
The news comes as the rate of vaccination nears 2 million doses per day on average, well above the 1.3 million pace seen in the final week of February, according to Bloomberg data.
Democrats, meanwhile, continue to push the president’s $1.9 trillion stimulus proposal to a Senate vote. The House passed the measure on Saturday, and Senate Majority Leader Chuck Schumer has said he aims to bring the bill to the Senate floor by mid-week. Biden ultimately aims to sign the package into law before expanded unemployment benefits lapse in mid-March.
The package is far from a done deal. Democrats are still haggling over some elements of the bill, including the size of a new supplement to unemployment insurance. The party needs all 50 votes to pass the bill through budget reconciliation, making any last-minute changes risky to the vote’s success.
Lyft rose after the company announced it enjoyed the best week for ridership since the start of the pandemic. Wedbush analysts on Tuesday named Lyft and Uber as top recovery plays, since reopening is expected to revive ride activity.
Bitcoin soared above $51,000 after trading as low as $47,118 on Tuesday. The run-up places the popular cryptocurrency at its highest levels since late February, when it tumbled from record highs.
Spot gold sank 1.7%, to $1,708.43, at intraday lows. The US dollar strengthened against Group-of-20 currencies and Treasury yields rose.
Oil prices shot higher amid the Treasury sell-off. West Texas Intermediate crude gained as much as 2.3%, to $61.10 per barrel. Brent crude, oil’s international benchmark, jumped 2.4%, to $64.18 per barrel, at intraday highs.
Experts are growing increasingly hopeful the US economy will rebound in 2021, but there’s a price to pay for that. The price of most things, actually.
A vaccine rollout, a $1.9 trillion stimulus package, and the lift in spending from December’s smaller stimulus paint a promising picture of a roaring, reopened America with lively restaurants, indoor dancing, and crowded stadiums. The economy is set for “stellar” growth as the pandemic subsides, a Bank of America note stated Monday, while boosting its 2021 GDP growth estimate to 6.5% from 6%.
It could all be the biggest boomtime in the US economy in a generation – but not without a cost.
While history indicates that the US likely won’t see an overheated economy after Biden’s massive stimulus package launches, Wall Street is predicting that certain goods and services might become more expensive.
JPMorgan’s David Kelly wrote in a recent bank note that high demand could “boost prices” across a range of services as the pandemic recedes over the summer, “maintaining inflation at or above” the Federal Reserve’s 2% target. And Mark Haefele, the chief investment officer of global wealth management at UBS, wrote on Tuesday that while fears about persistent rise in inflation are likely “overdone,” his bank is predicting that inflation may spike in the short-term.
“If pent-up demand emerges, prices could even rise above their pre-pandemic levels,” Brian Rose, senior economist at UBS Global Wealth Management, told Insider.
This may not be friendly news for Americans’ wallets, but higher prices and a demand for commodities without overheating is a sign of a healthier economy and a crucial next step toward the US’ economic recovery.
Rising Treasury yields – a famous barometer for future inflation – were in evidence this week, and Wall Street economists see signs that everyday essentials like houses, gas, and healthcare are about to get more expensive.
Stronger inflation? Treasurys say so
The Treasury market spoke up this past week. The 10-year yield, after steadily climbing through February, leaped as high as 1.614% on Thursday. The note now trades with its highest yield in more than a year, and President Joe Biden’s stimulus proposal is driving the economic optimism largely reponsible for this bond-market movement.
This matters because Treasury yields, especially in the 10-year, are an indicator of what investors think about the likelihood of inflation. It also matters because it could become a self-fulfilling prophecy.
Investors have largely priced in the $1.9 trillion in relief set to be approved by Democrats in the next few weeks. Supporters argue a large-scale deal is needed to bring the economy back to its past strength. Republicans have voiced concerns that the package will overfill the hole in the economy and spark rampant price growth.
Markets, at least for now, are siding with the Democrats. Expectations for stronger inflation lifted yields as investors demanded higher returns to offset price growth. The continued rotation to cyclical assets – those most likely to outperform during a rebound – saw cash rotate from defensive investments and to riskier plays.
But rising yields have consequences. Since Treasurys serve as a benchmark for the broader credit market, higher yields signal regular payments on consumer loans will soon swing higher.
Rates on car loans, for example, closely track the 5-year yield, Kathy Bostjancic, head US financial market economist at Oxford Economists, told Insider. Those notes saw outsize selling through the week as investors bet on a sharp but temporary rise in inflation.
Higher yields can be the canary in the coal mine for commodity prices. Treasurys reveal how investors expect the economy to perform in the future, and those expectations can influence current spending activity. Since commodity markets focus so much on contracts for future sales and purchases, yields influence those forward price curves.
“Heating oil and natural gas could perhaps be a problem,” Bostjancic said.
To be sure, yields are far from flashing warning signs of rampant inflation. Real yields, which subtract inflation from bonds’ nominal yields, are still negative across all maturities. Though the 10-year yield sits near one-year highs, negative real yields suggest investors aren’t yet fearful of uncontrollable price growth.
In fact, real yields began turning negative in 2019, well before the pandemic roiled the US economy. The recent uptick in yields is a healthy development, but the pace risks shocking the financial system at a critical turning point, Bostjancic said.
“The bottom line is the 10-year and the yield curve could have a ways to run, and that’s not necessarily negative,” she said. “But if it happens too rapidly, then it can be destabilizing. It could choke off this nascent recovery before it gets going.”
Homes, gas, and healthcare
So, what does this all mean for Americans’ wallets?
Well, the answer largely depends on what Americans want to spend money on the most. A UBS note this week predicted that largely looks like entertainment, personal services, and education – all key drivers in the experience economy.
“The biggest price increases are likely to be seen as a rebound to normal levels in those services that have been hit hardest [by the] pandemic,” Rose said, citing airfare and hotel stays as examples.
Gas, too, is going to get expensive. A recent Jefferies note revealed the energy sector has already seen a 23.6% increase in CPI, a bigger uptick than any other industry, as cars increased in popularity during the pandemic. Oil prices increased from $40 per barrel last summer to nearly $60 per barrel at present and will likely stay that way through 2021, per the JPMorgan note.
A pandemic, naturally, has also driven health spending up. The healthcare sector has seen a 14.7% increase in CPI, per Jefferies, signaling that Americans will have to pay even more for health care than they already are.
Then, there’s housing. The market has been booming, but buying a house has become more expensive. Interest rates hit a historic low in 2020, but the higher treasury yields signal that may be about to change. As of Thursday, mortgage rates climbed back to their highest level since August.
Mortgage lenders will hike up rates for borrowers to compensate for higher yields as they trade mortgage-backed securities on the bond market. “The market is looking out two or three years and thinking that rates are going to rise,” Todd Johnson, a division manager in Wells Fargo’s mortgage unit, told The Financial Times.
More expensive, but in a good way
Since price increases will be driven by stronger demand, Rose said, it’s an “encouraging sign that the impact of the pandemic is waning and life is returning to normal.”
The Treasury market’s latest moves suggest the Democrats’ stimulus package will prompt a sharp but temporary rise in price growth. Where inflation settles in the long term depends on how well the labor market heals, Seema Shah, chief strategist at Principal Global Investors, told Insider.
The Fed has indicated it won’t raise rates until it sees progress toward full employment. Once inflation runs hot for a period and unemployment declines, the central bank will move toward tamping down on inflation with higher interest rates.
Judging by the Treasury market, nobody expects the US to face runaway price increases, Shah said.
“The market is saying growth is going to be higher, therefore labor-market slack is going to disappear a lot quicker than people were anticipating,” she said. “And therefore the Fed will actually hike earlier than expected, and by hiking earlier than expected, we’re not going to see inflation take off.”
The Treasury market has made it clear: the Federal Reserve is a downer.
Optimism toward the US economic recovery flourished over the past week. Daily COVID-19 case counts fell further from their January peak. Vaccinations continued across the country, hinting the pandemic could fade in just a few months. Economic data beat expectations. And Democrats pushed forward with President Joe Biden’s $1.9 trillion stimulus proposal, aiming to accelerate the rebound even more.
And yet, these encouraging developments fueled a sudden shock in the Treasury market.
Investors looking to capitalize on a swift recovery dumped government bonds and pushed cash into riskier assets. The 10-year yield soared as high as 1.614% on Thursday, its highest level since the pandemic first slammed the US. The jump immediately cut into stocks’ appeal and dragged major indexes lower throughout the week.
The narrative behind the move is simple: The increased likelihood of new stimulus juicing the recovery lifted expectations for faster economic growth and inflation. Stronger price growth leads investors to demand higher yields.
Yet the market moved to such an extreme that it now stands in contrast with the Federal Reserve’s own forecast. The central bank has indicated it doesn’t expect inflation to reach its above-2% target until after 2023. The outlook suggests the Fed will hold interest rates near zero through 2023.
The sell-off in Treasurys, however, signals investors are pricing in a rate hike as early as the second half of 2022.
“We’re now getting to the point where the market isn’t necessarily believing what the Fed is telling,” Seema Shah, chief strategist at Principal Global Investors, told Insider. “We’ve now moved to a slightly more concerning ground, where it seems like the Fed’s messaging is not powerful enough.”
Too much of a good thing
Central bank policymakers have so far held their ground. The jump in yields suggests investors are expecting a “robust and ultimately complete recovery,” Fed Chair Jerome Powell said Tuesday. The chair reiterated that the Fed won’t cut down on asset purchases or consider rate hikes until it sees “substantial further progress” toward its inflation and employment targets.
At its core, the sell-off is merely part of the reflation trade, a strategy used to profit from stronger price growth. But the pace at which yields rose is cause for concern, Kathy Bostjancic, head US financial market economist at Oxford Economics, said.
Thursday’s leap was the biggest single-day move since December, and overall bond-market volatility rocketed to its highest since April, according to Bloomberg data. Finally, the gains came despite the Fed continuing to buy at least $80 billion in Treasurys each month.
Since yields serve as the benchmark for the global credit market, a sudden rise can rapidly lift borrowing costs, sending rates for mortgages, car loans, and even utilities higher.
If yields gain too much, too quickly, the price action can be “destabilizing,” Bostjancic said. The shock would come as real unemployment still stands at around 10% and industries hit hardest by the pandemic remain far from full recoveries.
“It could choke off this nascent recovery before it gets going,” she said.
Others aren’t so concerned. Bank of America strategists led by Gonzalo Asis said the trend was less inspired by rate-hike expectations and simply a case of “buying the fundamental dip” before strong economic growth.
There’s room for yields to climb higher still, Bostjancic said. Real yields – nominal yields adjusted for inflation – remain negative, signaling there’s still enough weakness in the economy to warrant parking cash in the safe haven.
Looking back to look ahead
To be sure, this is far from the first time markets have abruptly reacted to tightening fears.
Concerns of premature tightening of monetary policy fueled the now-famous “taper tantrum” of 2013, when investors rapidly dumped Treasurys after the central bank announced it would reduce the pace of its asset purchases, fueling a sudden – albeit temporary – shock to the bond market.
The Fed will likely move first in this case to avoid additional Treasury-market drama, Bank of America economists led by Michelle Meyer said in a Friday note. Updated economic forecasts set to be published after the Federal Open Market Committee’s mid-March meeting should offer some hints at when the Fed’s rate-hike criteria could be reached, the team said.
“The risk, however, is that the Fed won’t have the luxury of waiting for the next meeting and will have to respond to the abrupt market moves in speeches this week,” the economists added.
If the taper tantrum is anything to go by, communication is a difficult balancing act for the central bank. Powell has already said he doesn’t expect any stimulus-fueled jump in inflation to be “large or persistent,” but that commentary did little to calm the sell-off in Treasurys.
Unless the Fed further clarifies its inflation target, investors will remain in the dark as to when tapering could arrive, Shah said.
“There’s so much room for interpretation in terms of how long inflation has to be above 2%, at what level does inflation need to be above 2%,” she said. “That lack of clarity gives the market that room to wonder, ‘what does the Fed actually mean by that?'”