Enjoy the holiday slowdown, bond traders. If analysts at Deutsche Bank AG are right, the market is going to get a lot more volatile.
After the US Federal Reserve succeeded in nudging borrowing costs up from near zero last week in its first interest rate increase since 2006, Treasury yields have hardly moved. Now, traders are betting that low inflation and slow global growth will encourage policymakers to slowly raise rates next year.
The lull is not expected to last, according to Dominic Konstam, global head of rates research for Deutsche Bank in New York City. He predicts the Fed will catch bond traders wrong-footed by raising rates in March. That might prompt a smaller version of the market “tantrum” seen in 2013, when the prospect of an end to Fed bond buying fueled a sharp selloff in Treasuries.
“We call it a ‘baby tantrum,”’ Konstam said. “The idea is that the Fed’s tightening will look somewhat benign, and then you’ll realize that rates are rising to 1 percent. That’s a lot of stress” for markets.
The warning from Deutsche Bank comes as expectations for Treasury market volatility are tumbling. The Bank of America Merrill Lynch MOVE Index, which gauges implied volatility through options prices, fell to 66.02 this week, the lowest since December last year.
Early signals from the central bank indicate that policymakers might raise rates more quickly than traders expect.
The median of the Fed’s so-called dot plot — a chart sketching out officials’ projections for where rates will be in the future — calls for them to reach 1.375 percent next year. That would constitute four quarter of a percentage point increases. On Monday last week, Federal Reserve Bank of Atlanta President Dennis Lockhart also suggested that the Fed might raise rates four times next year.
Futures prices show traders do not buy into the Fed’s timeline. The market continues to expect two rate increases next year, according to data compiled by Bloomberg.
Traders are pricing in a 56 percent chance that the Fed raises rates at or before its April meeting, based on the assumption that the effective fed funds rate will trade at the middle of the new FOMC target range after the next increase.
The yield on the benchmark 10-year Treasury note rose four basis points, or 0.04 percentage points, to 2.24 percent this week. The 2.25 percent note maturing in November 2025 fell 10/32 to US$3.13 per US$1,000 face amount, to 100 2/32.
The last time the Fed sparked a Treasury-market tantrum, it wiped out about US$1.5 trillion of bond-market value globally, according to Bank of America indexes.
Konstam does not expect the same amount of damage this time around. He forecasts the 10-year Treasury yield is to peak at about 2.75 percent close to the middle of next year.
After that, he predicts the Fed will hold off from further rate increases to make sure financial conditions have not tightened too much. That would alleviate some pressure on government debt, prompting yields to fall back to around current levels by the end of the year.
Mitsubishi UFJ Securities USA Inc senior Treasury trader Thomas Roth said he is not willing to take a bullish stance on Treasuries. He thinks that the bond market is being too complacent and ignoring a risky cocktail of low coupons and high duration, a gauge of interest rate sensitivity.
“People feel comfortable because they feel the terminal rate will be low,” meaning the Fed will not raise rates as high as it did in previous cycles, Roth said from New York. “That may happen, but it’s not a bet I’d be willing to make.”
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