Bond Traders Gird for More Pain After Biggest Loss Since 1980

Everyone’s excited about the prospects for a sharp economic recovery as increasing numbers of Americans get their Covid-19 vaccinations. Well, almost everyone -- holders of U.S. Treasuries have serious reasons for concern. The debt is capping its worst quarter since 1980, when former Federal Reserve Chair Paul Volcker was trying to break inflation by sending rates soaring. And with the economy returning to normal, investors are bracing for higher yields and even more losses to come.

The Bloomberg Barclays U.S. Treasury Index sank 4.25% in the three months to March 31, as the bonds came under pressure after the Democrats took the Senate in January and paved the way for a surprisingly large $1.9 trillion spending program championed by President Joe Biden. Add the U.S.’s accelerated vaccine rollout and the Fed’s reluctance to push back against higher yields, and you get a selloff that drove the 10-year rate to the highest since January 2020.

Traders and investors see this dynamic extending into the second quarter -- and the rest of the year -- as the Biden administration seeks yet another multi-trillion dollar spending plan and further speeds vaccine deployment. However, the pace of the losses should be more contained, even as the specter of volatility looms.

In the first quarter, the market was “firing off on all cylinders when it came to the trajectory toward higher yields, because you had a pathway toward improving fundamentals,” Subareas Rajappa, head of U.S. rates strategy at Societe Generale, said. “I definitely see the case for a steady rise in yields from here on.”

Bond Traders Gird for More Pain After Biggest Loss Since 1980

Yields on the 10-year climbed more than 80 basis points during the quarter, peaking at 1.77% on March 30, an astonishing about-face after hitting a historic low of 0.31% in March 2020. The 30-year bond had a similar story. While the quarterly jump for both tenors was higher in 2016, the historically low starting point this time set the stage for bigger losses as yields rose.

Meanwhile, the breakeven inflation rate for 10-year Treasury inflation protected securities, a gauge of investor expectations for the pace of annual consumer price gains over the next decade, climbed 39 basis points over the quarter and at one point reached as high as 2.37%, a level unseen since 2013.

Yet, while that points to inflation running hot enough for the Fed to reach its 2% target, it’s still a far cry from the kinds of forces former boss Volcker sought to tame around four decades ago. And with the Fed’s target range for overnight rates solidly anchored near zero, and its quantitative easing program continuing apace, the picture in short-term yields and monetary conditions is vastly different.

Priced In Already?

By now, investors have largely priced in much of the encouraging news, so this type of “very disorderly” selloff is likely to abate in the second quarter, according to Bank of America strategist Ralph Axel. The risk is that the upbeat expectations about the recovery haven’t fully materialized yet, opening the door to possible shocks along the way.

“The range of outcomes is still very wide,” Axel said. “We’re talking about the darkest depths of the recession or one of the biggest possible growth years we’ve had in decades. We’re kind of teetering between those two possibilities.”

Bond Traders Gird for More Pain After Biggest Loss Since 1980

Bond investors are also likely to continue challenging the Fed’s resolve, Rajappa said. The most recent phase of the selloff has been led by five- to 10-year notes, which suggests investors are pricing in a more near-term removal of accommodation. Bank of America expects intermediates to underperform as rates continue to climb, Axel said.

A slew of Wall Street analysts see the 10-year ending 2021 at around 2%, but there’s potential for a move closer to 2.2% given the expected strong economic recovery, Loomis Sayles portfolio manager Peter Palfrey said. The speed limit on the U.S. economy has increased, meaning the Fed might need to raise its policy rate beyond 2.5%, which would portend higher yields. However, potential tax hikes to pay for the upcoming spending package could impede growth and temper the ascent, he added.

©2021 Bloomberg L.P.

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