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Analysis: U.S. bond derivatives signal calm, but economic fundamentals could spur more sell-offs

EconomyMar 02, 2021 11:55AM ET
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By Kate Duguid and Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) - After a sharp sell-off last week, U.S. Treasuries have stabilized with bond market indicators and derivatives positioning pointing to near-term calm, but an improving economy could trigger another slide in their prices.

The benchmark U.S. Treasury yield hit a one-year high of 1.614% on Thursday in what investors called a "tantrum without the taper," as the market sold off on expectations that an economic rebound would force the Federal Reserve to tighten monetary conditions sooner than anticipated. Yields have since retreated.

While yields could spike again, analysts and investors pointed to moves in inflation breakevens, swap spreads and put options on Treasury debt exchange-traded funds as evidence of temporary calm.

"The selloff may have run its course," said Jabaz Mathai, head of U.S. rates strategy at Citi, pointing to inflation breakevens backing down. The decline in breakevens, as well as tightening swap spreads, are the strongest signals yet that U.S. Treasury yields have peaked, said Mathai.

"I would not say the bear market in Treasuries is over at this point, but there is the prospect of a near-term pullback," said Mathai. "You should see some stability in the 10-year around these levels."

The U.S. 10-year inflation breakeven rate, the implied inflation rate at which an investor would break even buying either an inflation-adjusted 10-year note or a traditional 10-year Treasury note, declined to 2.16% on Monday, from 2.24% in mid-February.

The peak in Treasury yields is also evident in narrower U.S. swap spreads, a barometer of hedging activity against rate rises.

The spread on 10-year U.S. interest rate swaps over Treasuries fell to 7.5 basis points on Monday, from 9.75 basis points, the 11-month high hit last week.

"If swap spreads continue to roll over, that would suggest that hedging against higher rates may have peaked and another indication that rates would be stabilizing from here," said Mathai.

Graphic: U.S. swap spreads - https://fingfx.thomsonreuters.com/gfx/mkt/dgkplzywmpb/US%20swap%20spreads.png

Meanwhile, the trading volume of put options in BlackRock (NYSE:BLK)'s iShares 20+ Year Treasury Bond (NASDAQ:TLT) Exchange-Traded Fund, which investors use to bet on Treasury prices, had fallen by nearly 80% on Monday from last week's highs.

The decline in the trading volume of put options - which increase in value when prices fall - suggests some investors believe the bearish trend is over for now, said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group.

"When you see that record put volume, sometimes that can be a sign of capitulation," he said. "Particularly if a lot of it is investors closing puts, which is what we think was happening on Thursday."

The implied price volatility on TLT has fallen since peaking on Thursday, another indication investors are expecting a calmer market.

Still, there is continued evidence of data showing inflation and other aspects of the economy are on the rise, bolstering the case that upward pressure on yields could persist. Manufacturing data reported Monday showed the strongest growth in three years. The data also showed that prices paid by manufacturers were the highest since July 2008.

Signs of stress also remain, implying more episodes of turmoil - or "tantrums" as they have become known - lie in wait over coming months.

But some investors maintain that higher yields don't necessarily create problems for the Fed if markets don't panic in response.

"(The Fed) knew they were going to be dovish while at the same time we were getting better news," said Ritchie Tuazon, fixed income portfolio manager at Capital Group.

Investors will be closely watching remarks from Fed Chair Powell on Thursday at the Wall Street Journal's Jobs Summit, his last scheduled public speech before the FOMC's policy meeting on March 16-17.

Harley Bassman, managing partner at Simplify Asset Management, expects yields to rise slowly, with the 10-year yield moving as high as 4% within the next three to four years.

"Over the near term, I do think there is a big congestion between 1.5% and 2%. We spent six months at this level between mid- to end-2019."

Analysis: U.S. bond derivatives signal calm, but economic fundamentals could spur more sell-offs
 

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