Quick Thoughts: Making sense of Treasury jitters

Originally published in Stephen Dover’s LinkedIn Newsletter, Global Market Perspectives. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.

Following sharp declines in US and global equity markets, now the US bond market is tumbling. Ten-year US Treasury yields have jumped nearly 50 basis points in the past few days. In what follows, we explain the move and what it means for investors.

• The sharp rise in US Treasury yields, in our view, probably reflects selling for technical reasons, perhaps exacerbated by forced selling by unknown institutions facing margin calls. Rising bond yields do not reflect, for now, changes in expectations for inflation, debt, or global financial transactions.
• If the selling pressure intensifies, the Federal Reserve (Fed) may have to intervene. But it is not likely to be via interest rate cuts, in our view. Rather, technical injections of liquidity may be required.
• It is worth noting that today’s auction of 10-year US Treasuries was orderly, as demand appeared solid and yields began to fall.
• We begin with the facts—what is going on? Most importantly, long-term Treasury yields are rising sharply and much faster than short-term yields, leading to a steepening of the yield curve.
• Why is that happening? In theory, various factors could be behind the jump in bond yields. It might be that investors are worried about inflation, insofar as tariffs will boost US inflation. It could be that investors are worried about large US budget deficits and debt levels. Or it could be that investors are concerned that countries hit by tariffs, such as China or Japan, might stop buying Treasuries or even might sell their massive stockpiles of them.
• None of those reasons is, for now, compelling. Measures of expected inflation (based on Treasury Inflation Protected Securities or TIPS) do not evidence a sharp increase in investor expectations. As of April 8, the 10-year breakeven inflation rate from TIPS pricing is a subdued 2.22%. Deficits and debt expectations have not materially worsened. If anything, the tax revenues from tariffs represent fiscal tightening and the odds of the Tax Cuts and Jobs Act of 2017 being extended, and even a large tax cut this year, have not materially changed. Finally, if foreign central banks and reserve managers were slowing their purchases of Treasuries, the US dollar would be selling off in tandem with the bond market. While the dollar has softened a bit, it does not appear to be under similar selling pressures.
• The probabilities therefore suggest that leveraged positions in Treasuries (including basis trades or positions in swap markets) are the source of this week’s selling pressures. Of itself, that could be benign—or possibly not. If the selling pressure is contained, we believe little damage will be done. If, on the other hand, one or more financial institutions has gotten “over its skis” and is selling under duress, the Fed might deem it necessary to prevent further financial dislocations. However, the Fed’s engagement would probably not be via interest rate cuts, but rather via commitments to provide targeted liquidity.
• Finally, rising long-term interest rates, if sustained, represent a further tightening of financial conditions beyond declines in global equity markets or widening of credit spreads. In that regard, we think they represent a further risk to the outlook for US and global growth and corporate profits.