The US Treasury will have to pay a positive real interest rate on new 10-year borrowing for the first time in 18 months as investors get cold feet about a possible slowing of the Federal Reserve’s bond buying programme.
Bond investors are ditching Treasury inflation-protected securities, or Tips, pushing the inflation-adjusted or “real” Treasury yield above zero. It was minus 0.75 per cent as recently as April.
The surge in real yields highlights investor expectations that the Fed will soon start to slow the $85bn-a-month, third round of quantitative easing that it began last September. But investors say markets may be moving too far ahead of the central bank.
The Fed wants to slow its bond purchases as the labour market improves and it is likely to push back against market expectations of an automatic end to QE.
In his press conference next week, Fed chairman Ben Bernanke is likely to repeat the possibility of tapering QE, but emphasise that a decision to do so will be closely tied to the economy and in no way signals that the Fed is closer to raising interest rates.
“We have known for some time that Tips were overvalued, and the reversal has happened very quickly,” said James Evans, senior vice-president at Brown Brothers Harriman. “Rightly or wrongly, the bond market has pulled forward the end of QE and rate hikes coming as early as 2014. It does seem premature.”
Michael Pond, interest rate strategist at Barclays, said: “The bond market seems to be missing the point that the Fed’s policy of tapering depends on the tone of economic data.
“The market has moved from pricing in less bond buying to a full-on tightening cycle and we believe that is a different story than what the Fed is trying to communicate.”
Tips provide investors with protection from inflation, meaning their prices rise as inflation goes up. Investors bought them on the expectation that the Fed’s stimulus efforts would lead to higher consumer prices.
The demand for Tips was so heavy that over the past 18 months, investors accepted a negative real yield on the securities, hoping for a capital appreciation as inflation accelerated.
But since the start of the year, investors have been dumping the bonds as inflation has fallen. The move has accelerated in recent weeks as bonds of all kinds are selling off on the expectation that the Fed will start trimming QE later this year.
The Fed is unlikely to be concerned by the rise in yields if it reflects investor expectations that the economy is on the mend. After next week, the Fed meets again in July and then September.
So far this year, nearly four times as much money has been withdrawn from the iShares Barclays Tips exchange traded fund of $3.45bn than was pulled from the ETF in 2012.
“No one wants to own Tips and the lack of Fed talk as yields have risen suggests they are letting the market feel its way,” said Michael Kastner, managing principal at Halyard Asset Management.
Get alerts on Federal Reserve when a new story is published