Bond Traders Envision Road Map to 2% Yield on 10-Year Treasuries

(Bloomberg) -- A relentless global bond rally has Treasury investors pondering what it will take to send benchmark 10-year yields below 2% for the first time since 2016.

Rates on 10-year Treasuries dipped lower again on Thursday, after touching about 2.21% the day before -- almost 50 basis points below where they started the year -- amid U.S.-China trade tension and concern over the outlook for the world economy. The flight to safety saw the spread between 3-month and 10-year yields dive to its most inverted level since 2007, as the bond market’s recession signal intensified.

Against that backdrop, here’s what portfolio managers and strategists envision as potential triggers for another leg lower in yields, to levels last seen in the days after the 2016 U.S. presidential election:

Trade Turmoil

Geopolitical pressure points ranging from souring U.S.-China relations to re-emerging Brexit angst mean that risks are skewed to lower yields, according to Societe Generale SA strategist Subadra Rajappa. Investors coming to grips with the reality of a drawn-out U.S.-China trade standoff spurred a round of short-covering, she said.

“The market is coming to the realization that U.S.-China trade negotiations are likely to be protracted,” she said. “Too much optimism was priced in for a positive outcome, and we are now seeing a gradual unwind of that.”

Haven demand over an extended period of uncertainty puts 2% yields on 10-year notes within “the realm of possibility,” Rajappa said.

Additionally, yields should fall further as traders price in the Federal Reserve’s policy path -- SocGen anticipates 100 basis points of easing in 2020, while fed funds futures show that roughly 75 basis points are priced in by the end of next year.

Data Watch

A move to 2% on the 10-year is possible should U.S. economic data soften and spur traders to further ramp up Fed easing bets, according to Gene Tannuzzo, deputy global head of fixed income at Columbia Threadneedle Investments. He’ll be keeping an eye on reports including next week’s manufacturing update from the Institute for Supply Management.

“We could easily get there” should the ISM gauge fall below 50, he said. A deterioration in U.S. economic figures would “solidify cuts from the Fed.”

ISM manufacturing is forecast at 53 for May, up from a prior reading of 52.8, which was the weakest since 2016. That year was also the last time it was below 50, which would indicate contraction.

Refi Boost

Then there’s the matter of mortgage-related hedging. As yields fall, some homeowners will look to refinance loans. That could complicate things for investors in mortgage-backed debt, whose strategies partly depend upon forecasting how many loans will be repaid early.

Plunging Treasury yields threaten to speed up prepayments, forcing mortgage investors to re-calibrate their positions. Should 10-year yields drop much further, that hedging flow could add demand for Treasuries, according to Brean Capital LLC.

“We continue to view the 2.20 - 2.25% level as being critical for mortgage convexity-related buying, which could temporarily exacerbate declines in rates,” Russ Certo, a Brean managing director, wrote in a note Wednesday. A break below that range would put the spotlight on resistance levels at 2.125% and then 2.03%, he said.

To be sure, not everyone is convinced yields will trend lower this year.

Aberdeen Standard Investments is shorting the two- and five-year notes on expectations growth will remain robust, while Western Asset Management reckons global bonds could be heading for a correction. Citigroup Inc. recommends investors take profit in long 10-year Treasury positions, while Wells Fargo & Co. sees yields ending the year around 2.75%.

--With assistance from Liz Capo McCormick, Edward Bolingbroke, Stephen Spratt and Ruth Carson.

To contact the reporter on this story: Katherine Greifeld in New York at kgreifeld@bloomberg.net

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Mark Tannenbaum, Nick Baker

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