As bond yields have tumbled because of the Federal Reserve’s lower interest rates for longer monetary stance, investors have compensated by buying longer duration bonds.
The logic is pretty simply. A one-year Treasury now yields 0.11%. A two-year Treasury pays 0.45%. A five-year Treasury yields 1.18%. The benchmark 10-year Treasury was paying 1.61% at the close today, October 26. Want more yield? You can buy the 30-year Treasury for a yield of 2.04%.
The problem is that the longer the duration of a bond–the more time until maturity–the bigger the downward move in bond prices if/when the Federal Reserve decides to raise interest rates or if/when the financial markets decide to anticipate a Fed move by selling bonds ahead of any move by the U.S. central bank.
Investors exposure to duration is near record highs, according to Bloomberg. Which means that even a modest rise in bond yields would produce massive–trillions–in losses.
The Wall Street consensus is that 10-year Treasury yields, which closed at 1.61% today, will reach 2% a year from now. That would put them in range of their 2.14% average for 2019.
That doesn’t seem like much of a move higher. But, according to Bloomberg, it would be enough to produce hundreds of billions in losses in the $10 trillion Treasury market.
A half-point increase in yields would result in $350 billion in losses in the Bloomberg U.S. Treasury index, which tracks bonds with a market value of $10 trillion. The hit to the $68 trillion Bloomberg Global Aggregate Index–which includes corporate and securitized bonds of both developed and emerging markets–would be around $2.6 trillion.
And that’s just from a move of 50 basis points to 2.20% or so.
The scenario may not come true. Bond market bulls argue that yields will fall n 2022 as inflation proves to indeed by “transitory.”
But so far this year the bond market is following the bearish scenario of higher yields and lower bond prices. Bloomberg’s U.S. Treasury index has declined 3.3% this year through Oct. 21, on course for its biggest annual loss since 2009.
Which has led to a self-fulfilling prophecy as investors move to alternatives to bonds–which, of course, pushes bond prices lower. The latest Bank of America monthly fund manager survey showed they’re the most underweight in their bond allocation ever.
Watch this week’s report on the September Personal Consumption Expenditure index, the Fed’s preferred measure of inflation. In August the PCE rose at a 4.3% annual pace, the highest in more than a decade. The September PCE report is due on Friday, October 29.
The Fed has also created the expectation that it will start reducing its monthly $120 billion in purchases of Treasuries and mortgage-backed securities as early as its November 3 meeting.
