(Bloomberg) – The bond market’s message after the latest brief rise in yields is clear: The Federal Reserve stands ready to prevent an alarming rate hike, no matter how much debt the Treasury sells amid the pandemic .
Investors have been acting for months as if the Fed has already unleashed one of the tools remaining at its disposal – control of the yield curve, a policy of capping rates to keep them from rising too quickly and stopping an economic rebound. . And this week was no exception.
The old adage “Don’t fight the Fed” is at work here. The mere prospect of central bank action keeps yields close to historic lows. In the world’s largest debt market, yields are stuck in such a narrow range that there is little precedent, even after rates hit a four-month high on Wednesday, hinting that a U.S. plan relief against coronaviruses could take shape.
As they have been doing for months, buyers have seen their yields drop. The buy preserved the sentiment of calm in fixed income that persisted despite the Fed’s August pledge to let the economy heat up to fuel inflation. This episode only fueled demand as yields climbed towards 1%. These are revealing lessons for investors of all asset classes, less than two weeks before the U.S. election that could pave the way for an even bigger wave of government spending.
“Yields behave almost as if we are already controlling the yield curve,” said Esty Dwek, head of global market strategy at Natixis Investment Managers, which oversees around $ 1 billion. “The rise in yields will likely remain contained because the Fed is more important than anything else and it will limit it.”
Call it stealthy control of the yield curve, as Fed policymakers have pushed back on the idea of capping yields. This is a step that the central banks of Australia and Japan have already taken. The Bank of Japan has pegged 10-year rates at around zero, while the Reserve Bank of Australia is targeting three-year yields at 0.25%.
In the United States, yields have been cashed in both directions. On the upside, the Fed’s potential for action should the economy darken, along with overseas buying and safe-haven demand amid pandemic concerns, are keeping long-term yields in check . On the downside, the central bank’s reluctance to lower policy rates below zero creates a floor.
Stuck weather vane
The result is that the yield on 10-year Treasuries, the benchmark for global bonds and a key weather vane for equity investors, fell only 23.2 basis points high and low in September and October. It would be the narrowest two-month range since 2018 and one of the smallest for the past two decades.
The rate is now at 0.81%, and the options market this week has seen trades targeting yields hold at current levels for the remainder of the year. The consensus on Wall Street is that the 10-year will not eclipse 1% until 2021.
With speculation that a November sweep of Democrats could lead to oversized stimulus spending and higher yields, the placidity of the bond market could be a source of solace for equity investors. There may be less reason to fear a sell-off similar to the so-called taper tantrum of 2013, when yields surged after Fed Chairman Ben Bernanke suggested the central bank could cut back on asset purchases. .
US taxpayers also benefit from low rates. The Treasury is selling record amounts of debt, but it just ended a fiscal year paying the least to honor the country’s obligations since fiscal 2017.
The Fed still buys about $ 80 billion in treasury bills and at least $ 40 billion in mortgage securities per month. Policymakers said in September that they would continue to buy at least at this rate to “keep the market functioning well and help foster accommodative financial conditions, thereby supporting the flow of credit to households and businesses.”
Powell and his colleagues have pushed lawmakers to step up fiscal stimulus, stressing that there is little monetary policy can do to combat the long-term effects of the pandemic. Still, if the deadlock persists in Washington, it could lead the Fed to do more.
The minutes of the Fed’s September meeting signaled a willingness to review the bond buying program and possibly modify or increase buying, in addition to keeping policy rates close to zero at least. until 2023. Officials have suggested they may shift some purchases towards long-term debt. create greater downward force on rates. They played down the idea of performance caps, but most economists still see it as a possible tool.
Jim Caron of Morgan Stanley Investment Management says he “slowly takes advantage” of buying opportunities when the yields on 10- and 30-year Treasuries rise. He predicts the 10-year rate will not rise above 1.25% and expects the Fed not to raise rates until at least 2024 or maybe 2025.
“Interest rates will be low for an extended period, which means a limited safeguard of rates,” he said. “We still hold treasury bills and would be happy to buy more if rates went up and exceeded our upside expectations.”
Fed actions also boosted demand for Treasuries from US banks and foreign investors. U.S. commercial banks have increased their holdings since the Fed eased some regulatory requirements in April in hopes of reversing a liquidity deficit.
“If the United States recovers faster thanks to a robust fiscal stimulus and presumably a vaccine, we could see an increase in yields,” said Alex Etra, senior Exante Data strategist who previously worked at the New York Fed. “But if you get a very rapid ramp-up that risked derailing the recovery, that’s definitely a case where the Fed would step in,” he said, noting policymakers’ discussions last month over the extension. the duration of the Fed’s treasury. wallet.
“It’s not exactly a control of the yield curve, but it is clearly intended to reduce the likelihood of long-term yields rising,” he said.
Any increase in yields should attract foreign investors as well, with over $ 16 trillion in premium global debt producing less than zero. With hedging costs falling and the US yield curve steepening, the rally in 30-year Treasuries for euro-hedged investors is around 80 basis points above German bunds.
The Fed’s decision this year to strengthen currency swap lines has helped make pricing more attractive to currency hedging operators, says Zoltan Pozsar of Credit Suisse Group AG. And while central banks have pulled out of swaps, the lines still create a safety net to keep hedging costs low.
“There are two policemen who will keep long-term Treasury yields from rising too high: the Fed and foreign buyers, who can get cheap currency hedges through the Fed’s swap lines,” said Pozsar. “It’s the Fed police at the end of the day, anyway.”
(Updates with everything under the third paragraph.)
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