December 23, 2011 7:01 pm
Twist in the tale of bond market’s orphan asset
In characteristic low volume trading ahead of Christmas, the rise in long-dated Treasury yields this week has stood out with 30-year bond yields jumping back over 3 per cent from Monday’s low of 2.78 per cent.
Higher yields, accompanied by tumbling prices, have occurred after the US Federal Reserve completed its final bond purchases under “Operation Twist” for this year.
That temporary halt in Fed support only demonstrates the power of central bank buying in keeping long-term interest rates at low levels that, over time, are designed to stabilise the housing sector and ultimately boost the economy.
There is no question that the Fed’s purchases of long bonds that began in August have helped power substantial returns for bond investors with the Barclays Capital index of long-term Treasuries up 28 per cent this year, its best annual run since 1995.
It is a performance very few on Wall Street expected this time last year when the 30-year bond was anchored around 4.50 per cent.
Even by late July, the bond was only a touch lower in yield at 4.30 per cent.
Then came the escalation in the eurozone debt crisis and evidence of much weaker US growth that, in turn, compelled the Fed to start buying more Treasuries.
But the real twist in the Fed’s late summer policy for bond managers was that the central bank did not focus its efforts on the 10-year sector as many investors had expected.
Instead, the Fed under Operation Twist is, in effect, removing 90 per cent of new 30-year bond issuance until its purchases end next June. Buying of that magnitude explains why the Fed’s purchases are viewed by traders as having artificially lowered market yields by at least one 1 percentage point.
As we move into 2012, the resumption of Fed buying should cap the rise in bond yields, but the outlook for another year of big gains for the sector looks slim.
In recent weeks, Wall Street dealers have notably halved their holdings of long-term Treasuries to $8bn after they peaked at $15,155bn in October.
Staying bullish on long bonds requires a gloomy prognosis for the US and global economy along with a complete breakdown of the eurozone next year.
This week, Pimco forecast that the US economy might only expand between zero and 1 per cent in 2012 with growth hurt by Europe’s debt crisis and a slowdown in China.
That may come as no surprise given Bill Gross, co-chief investment officer at Pimco, has taken the Fed’s Twist to heart and heavily weighted his total return fund in favour of long-dated bonds.
But should the US economy falter, expect a proactive response from the Fed that would likely end the Twist and begin a new round of quantitative easing, or QE3.
Another round of QE would likely focus on buying mortgage securities and fan long-term inflation concerns, a key driver of 30-year bonds.
Once the Twist ends, long-term yields should rise as current core inflation sits above 2 per cent and investors need more than a slim 3 per cent coupon on 30-year paper over the long term.
It is worth recalling that before the advent of Operation Twist, the 30-year bond was often dubbed the “orphan” of the bond market as it traded in a world of its own and was only sought by pension and insurance funds seeking to offset long-dated liabilities.
Indeed, these players would certainly like to see higher yields at some stage in 2012 and are likely to wait and see how much the long end backs up once the Fed ends the Twist or embarks on new stimulus that fans long-term inflation worries.
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Investors should be mindful that orphan status and yields heading towards 4 per cent may loom for the bond in 2012, once the Fed no longer corners this sector of the Treasury market.
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Copyright The Financial Times Limited 2011.
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