(Bloomberg) — Yields on U.S. government debt blew past another set of closely watched levels, with a key part of the Treasury curve surging past an inflection point that’s seen as potentially squelching global speculative euphoria.
Yields took off with startling speed, with the rate on 10-year Treasuries reaching 1.61%, the highest in a year. In a telltale warning sign for some strategists, the 5-year Treasury yield soared convincingly above 0.75% on Thursday, a crucial level that was expected to exacerbate selling, as traders pulled forward bets on when the Federal Reserve will start lifting policy rates. The 10-year U.S. real yield — which strips out inflation and is seen as a pure read on growth prospects — climbed as much as 25 basis points to a level last seen in June.
The latest leg in this frenetic fixed-income tumble came on a sudden wave of selling after demand cratered at the Treasury’s 7-year note auction Thursday. Yields globally are now reaching levels last seen before the coronavirus spread worldwide. Central banks have attempted to soothe markets, with European Central Bank chief economist Philip Lane saying the institution can buy bonds flexibly and Fed Chair Jerome Powell calling the recent run-up in yields “a statement of confidence” in the economic outlook. While higher real rates signal growth is gaining traction, investors are becoming uneasy over the sustainability of the recovery, and whether stimulus will feed into ever higher prices.
The 5-year note leading the rout “is a warning signal that the rates selloff is going beyond a repricing towards a convexity move,” said Peter Chatwell, a Mizuho International Plc strategist. “This is something which we think is inconsistent with Fed dovish rhetoric on rates.”
Convexity Fuel
Adding to the bond slump are forced sellers in the $7 trillion mortgage-backed bond market, who are likely unloading the long-maturity Treasury bonds they hold or adjusting derivatives positions to compensate for the unexpected jump in duration on their mortgage portfolios. It’s a phenomenon known as convexity hedging, and the extra selling has a history of exacerbating upward moves in Treasury yields — including during major “convexity events” in 1994 and 2003.
Convexity Hedging Haunts Markets Already Reeling From Bond Rout
The 5-year note is of particular interest to many in the $21 trillion Treasuries market. Earlier this week, tepid demand in an auction of five-year notes brought into focus this key part of the curve, which also reflects medium-term expectations for Fed policy. Then on Thursday, a measure of demand for a $62 billion auction of 7-year Treasury notes came in at a record low.
The rout comes as investors continue to reprice expectations for Fed hikes as the vaccine rollout and the prospect of additional stimulus foster a rosier outlook for the economy. Yields on 2- and 5-year yields are more influenced by the starting point and speed of normalization, said Bank of America Corp. rates strategist Ralph Axel.
“Everything that we see keeps pushing us into sooner, faster, more in terms of removing accommodation,” Axel said.
The surge in yields is hurting riskier assets. Emerging-market currencies such as the South African rand and Mexican peso sold off sharply against the dollar, and the S&P 500 Index dropped as much as 2.6%.
In Europe, peripheral countries have led a bond sell-off, with Italy’s 10-year yield spread over Germany climbing back above 100 basis points. Core debt wasn’t spared, with yields on France’s benchmark debt turning positive for the first time since June.
Officials’ Disquiet
Economic leaders are making clear their disquiet. Apart from ECB’s Lane, Executive Board Member Isabel Schnabel weighed in, saying in an interview published Thursday that the central bank has a close eye on financial markets because a sudden rise in real rates could pull the rug out from under the economic recovery.
Elsewhere, the Bank of Korea warned it will intervene in the market if borrowing costs jump, while Australia’s central bank resumed buying bonds to enforce its yield target. The Reserve Bank of New Zealand on Wednesday promised a prolonged period of stimulus even as the economic outlook there brightens.
“You have to look at real yields,” Christian Nolting, chief investment officer at Deutsche Bank Wealth Management, said in a Bloomberg Radio interview. “If real yields are really rising and rising fast, that in the past has always been an issue for stocks.”
(Updates levels throughout.)
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