Treasury Yields' Retreat Signals Economic Woes

By Julia-Ambra Verlaine and Sam Goldfarb

A selloff in U.S. government bonds that pushed yields to the highest levels since March petered out almost as quickly as it started, a sign economic pessimism and aggressive monetary stimulus remain powerful forces suppressing longer-term interest rates.

The yield on the benchmark 10-year U.S. Treasury note dropped back below 0.7% Thursday, after mounting coronavirus cases upended investors' hopes for a return to economic normalcy. The move followed another steep decline Wednesday, after the Federal Reserve said it had no plans to raise short-term rates through 2022 and would continue buying Treasurys at a pace of at least $80 billion a month.

A critical benchmark for borrowing costs on everything from mortgages to student loans, the 10-year yield has remained stuck for months near record lows following the Fed's sweeping intervention to quell violent price swings earlier in the year. But it jumped as high as 0.959% last week, according to Tradeweb, after a series of data reports suggested the economy might be on stronger footing than expected.

That prompted investors to trade out of bets on worst-case scenarios, such as sustained mass unemployment or a general decline in prices, known as deflation. Bond-trading desks said volumes were high as asset managers scrambled to unwind positions and reassess the landscape.

But the move higher in yields screeched to a halt this week as such worries resurfaced. Despite last week's data and a stock market that has recouped much of its pandemic-era losses, many investors still see little reason to expect a big surge in economic growth and inflation, which would erode the value of their fixed coupon payments.

"Rates probably had gotten a little ahead of the data, and [Wednesday's] Fed meeting reminded the market that they aren't going anywhere anytime soon," said Robert Dishner, a portfolio manager at Neuberger Berman. He's holding on to Treasury inflation-protected securities and thinks rates in longer maturities will remain stuck in a narrow range. "The recovery is likely to be uneven."

Many investors are also confident the Fed will do what it takes to keep long-term rates from rising much higher because higher yields translate into steeper borrowing costs for businesses and consumers, potentially crimping economic activity.

Everything officials released on Wednesday, from their policy statement to their interest-rate forecast "has enhanced the Fed's commitment to keep rates low," said Jay Barry, head of USD government bond strategy at JPMorgan.

Behind last week's rise: hiring data that showed the U.S. unexpectedly added jobs in May, a sign the labor market is recovering after shutdowns earlier in the year. Other reports released around the same time showed declining activity in the manufacturing and service sectors but at a slower pace than in April.

That left asset managers debating whether the jump reflected the same hopes for a rapid economic rebound that carried the Nasdaq Composite to a fresh highs, or if investors were simply reassessing how long it would take to get U.S. consumers back on airplanes and into restaurants.

"I err on the side that this is an unwind of the deflation trade," said Rick Rieder, chief investment officer of global fixed-income at BlackRock Inc.

The moves in bonds have contrasted with those in stocks, which have rallied for weeks even while ultralow Treasury yields signaled deep concerns about the economy. The 10-year yield tends to rise when people expect economic growth and inflation and to fall when the outlook darkens.

And investors' recent appetite for riskier assets has extended beyond stocks. As of Wednesday, the extra yield investors demand to hold U.S. speculative-grade corporate bonds over U.S. Treasurys was just 5.74 percentage points -- down from 7.57 percentage points on May 15, according to Bloomberg Barclays data.

Other factors are also in place that could theoretically push yields higher -- notably the record levels of debt the U.S. Treasury is issuing to fight the economic damage caused by the pandemic and monthslong lockdowns.

After initially leaning on short-term Treasury bills to fund the trillions of dollars in economic-relief programs passed by Congress, the Treasury Department in early May announced an even larger shift to longer-term bond sales than many analysts were expecting -- increasing the size of regular 10-year note auctions by $5 billion and 30-year bond auctions by $3 billion.

Supply pressures have further been exacerbated by a deluge of bond sales from companies looking to stock up on cash as they try to weather the economic downturn. Nonfinancial companies have sold more than $650 billion of investment-grade bonds in the U.S. market since the start of March, shattering previous issuance records, according to Dealogic.

Some analysts argue that longer-term Treasury prices could still drop sharply again if economic data improve and the supply of new bonds overwhelms what the Fed is willing to purchase.

"The key risk for fixed income remains that policy makers lose control of the long ends giving rise to a 'tantrum' selloff, given record issuance and better data," strategists at Oxford Economics wrote in a Thursday note.

Write to Julia-Ambra Verlaine at [e-mail] and Sam Goldfarb at [e-mail]