(Bloomberg) — The Treasury market may be just one spark away from exploding and sending 10-year yields all the way up to 2%, suggesting that the rout of 2021 may not yet be over and raising the chances that other assets like emerging-market bonds might also be living on borrowed time.
Analysts are now putting the target on Treasury yields around half a percentage point higher than current levels following the rapid, reflation-fueled selloff that took the market by storm last week. Should that happen, it’s not just developed markets that will be left reeling. Developing-market bonds are increasingly at risk as investor concern grows about stretched valuations and the chances of a policy misstep by the Federal Reserve.
“The velocity of the moves in U.S. Treasury yields are now intensifying at a time when both hard currency and local emerging-market bonds are more vulnerable to such a move,” said Lisa Chua, a New York-based portfolio manager on the emerging-markets debt team at Man Group Plc’s hedge-fund unit Man GLG.
The reason 2% is on the radar for many is the market is in the midst of a rapid repricing back to a normal economy. What still hasn’t been priced in, among other things, are a much-sooner-than-expected cycle of interest-rate hikes and a real yield — which strips out inflation — closer to zero than the current level of around minus 0.8%. The record-breaking rally in stock markets meanwhile has been buffeted by the pick up in bond rates.
More analysts are sounding the alarm that there’s little to stop yields surging higher. ING Groep NV says investors’ attitude toward holding longer-dated Treasuries has grown cautious, “to put it mildly,” exacerbating the potential for rapid selling on any sign of weakness in the market. They see yields on 10-year Treasuries rising another 50 basis points, joining the likes of BNP Paribas SA who also expect 2% by year-end.
Investor jitters were on display again Wednesday, when a bigger-than-expected bond sale plan from the U.K. caused ructions globally. The U.S. 10-year yield jumped to around 1.49%, closing in again on the one-year high above 1.60% that it reached last Thursday in the wake of a sloppy seven-year Treasury auction. The rate was around 1.47% Thursday morning in New York.
Concern over supply hitting the market is adding to fears inflation is set to accelerate, which could force central banks to begin tightening policy. Then there’s the risk liquidity evaporates to fuel sharper moves.
“The bond market has been sitting on a powder keg since last week,” wrote ING strategists led by Padhraic Garvey in a note to clients. “In this context, we do not blame investors for exiting at the first sign of a selloff.”
Liquidity in the $21 trillion Treasury market, which underpins the global financial system, is under scrutiny following last week’s startling gyrations and weak auction demand. The gap between bid and offer prices for 30-year bonds hit the widest since the panic of March 2020.
All eyes will be on an appearance on Thursday by Federal Reserve Chairman Jerome Powell to see if he hints at possible action by the central bank to cap recent moves. In comments last week — before the violent gyrations on Thursday — he indicated that the Fed sees rising yields as a sign of economic health. But that message could well be shifted.
The European Central Bank, meanwhile, has indicated it sees no need for drastic action to curb the rise in longer-term borrowing rates.
For ING, the five-year U.S. bond is the key barometer for where rates are going. Mizuho International Plc agrees, having signaled the 0.75% level — broken a week ago — as the threshold that could signal a sharp correction in riskier stock and credit markets. That yield was hovering at 0.72% Thursday.
Emerging markets, though, are starting to tell a different story. For bonds there, the crunch point could come with 10-year Treasury yields holding north of 1.5%. For Lisa Chua at Man GLG, that could trigger “major outflows” in both hard-currency and local assets.
Not all investors see the path higher for yields. Some, like PGIM Fixed Income’s Robert Tipp, are betting on Treasuries going the other way and sending rates back down to 1% on the belief that the stimulutive effect from U.S. President Joe Biden’s $1.9 trillion spending package will fade and the economy will slow.
Right now, the selling momentum seems hard to shake, with the eagerness of investors to borrow and short 10-year securities creating a rush within the market for repurchase agreements that’s sent rates there deeply negative.
BNP strategists see the market pricing in an interest-rate hike from the Fed at the end of 2022, leading them to raise their year-end Treasury yield forecast to 2%. While they see the Fed sticking with dovish rhetoric, their risk scenario is that doesn’t work and the central bank has to increase the pace of bond purchases beyond the current $120 billion per month.
“A break in asset market correlations and collapse in UST market liquidity (all out taper tantrum or “T”) would likely facilitate a Fed response to limit the deterioration in financial conditions,” wrote BNP strategists including Sam Lynton-Brown. While no Fed rate hikes are expected until the end of 2022, “this does not prevent the market from pricing it in.”
(Updates with stocks in fourth paragraph.)
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