Cracks are forming in the market’s bullish consensus for bonds, as resurfacing fiscal concerns duel with expectations that cooling inflation will push the Federal Reserve to cut interest rates in coming months.
Bullish investors believe the explosive rally bonds experienced in late 2023 is likely to continue into this year, if the Fed loosens monetary policy as expected. Futures tied to the Fed’s main policy rate on Friday showed investors pricing in more than 150 basis points of cuts - twice the amount policymakers projected last month.
Not so fast, say the bears. While expectations for Fed easing may be driving bond prices now, some believe U.S. Treasury issuance, expected to nearly double to $2 trillion in 2024, could be a counterweight. Yields - which move inversely to bond prices - would have to rise from current levels to entice demand for the flood of new debt, they say. Such concerns helped drive Treasury prices to 16-year lows when they intensified in October.
So far, Treasuries have seen a nascent early year selloff, with yields on the benchmark 10-year Treasury up 16 basis points from their December lows. Net bearish bets on some long-term Treasury maturities in the futures market have surged to their highest level since October, data from the Commodity Futures Trading Commission showed.
“There’s really an outrageous amount of U.S. Treasury supply coming from the lack of fiscal discipline in this country, and we don’t necessarily see who the buyers are,” said Chris Diaz, portfolio manager and co-head of fixed income at Brown Advisory.
That is “going to be a real headwind for the long-end of the market to continue to rally,” he said, as longer-dated maturities are more vulnerable to fiscal concerns.
In a survey of investors by BofA Global Research, 23% said a bet on lower Treasury prices was their “highest conviction” trade for 2024, while 21% said the same for bets on higher Treasury prices.
This was a “moderate reversal” of earlier bullish calls on bonds, the bank’s analysts wrote on Friday.
Worries over U.S. debt sustainability heated up last year, when a credit rating downgrade by Fitch and higher Treasury issuance plans last summer fueled a bond selloff that saw the 10-year yield top 5%, its highest level since 2007.
The slide in bonds also sharpened investor focus on the measure of term premiums - the additional compensation bond holders demand for the risk of holding long term debt - which turned positive in September for the first time in two years.
Mounting expectations of a dovish Fed pivot saw bond prices reverse in the final months of 2023. But some investors believe bonds may have already factored in future declines in interest rates, making them vulnerable if fiscal concerns return.
“As we get into 2024, the total level of Treasury issuance is going to be very critical, whether there’s buyers for that paper,” said Tony Roth, chief investment officer at Wilmington Trust. Signs that inflation is stickier-than-expected could complicate the picture, Roth said, as inflation erodes the value of future bond payouts, making so-called real yields less attractive.
FED TO THE RESCUE?
Some of these worries could be offset by the return of the Federal Reserve as a buyer in the Treasuries market, potentially helping contain rising long-term yields.
Since June 2022, the Fed has reduced its balance sheet by over $1 trillion through quantitative tightening - a reversal of the massive central bank bond purchases undertaken to support markets as the coronavirus hit in 2020. But some Fed officials recently said the central bank should start considering slowing down and ending the shrinkage of its bond holdings.
JPMorgan analysts said last week that an earlier-than-anticipated end of quantitative tightening could improve supply-demand balance in the Treasury market as fewer government bonds would be sold to the private sector.
The end of the balance sheet runoff “could lead to duration rallying and a little more support for 10- and 30-year (Treasuries),” said Pramod Atluri, fixed income portfolio manager at Capital Group.
A return of the Fed in the market could also, over time, change the composition of Treasury issuance, with longer-term debt securities gaining a larger share after increases in their sales were contained in recent months.
“If the Fed goes back to buying bonds, maybe the Treasury can go back to issuing in more normal fashion,” said John Luke Tyner, fixed income analyst and portfolio manager at Aptus Capital Advisors. “The Fed’s balance sheet can soak up some of those bonds.”
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