There’s Less Panic, But Bond Yields Just Sank to Record Lows Again

(Bloomberg) -- Bonds continued their unrelenting rally on Wednesday, and although there’s no whiff of the panic that swept through markets late last week, the surge nonetheless drove benchmark yields down to unprecedented levels.

The rate on 30-year U.S. Treasuries sank to a record low of 1.90%. German and Italian benchmarks also sank to levels never seen before.

There was a striking difference between this yield-suppressing rally and Friday’s: U.S. stocks are climbing Wednesday, but the S&P 500 suffered one of its worst losses of the year at the end of last week. Wednesday’s drop appears more driven by technical factors -- such as investors needing to add long-term bonds to their portfolios as a hedge -- not anxiety about the economy. Friday’s trading session was stirred up by Donald Trump’s threat to retaliate against Chinese tariffs.

“The price action reflects a variety of market participants’ fears that their business model will be highly strained if rates fall to very low levels for an extended period,” Michael Cloherty, head of U.S. interest rate strategy at RBC Capital Markets, said of Wednesday’s trading. “So they need to add duration as a hedge against the possibility of a very low rate environment.”

Going long bonds is not a new trade. U.S. yields have been tumbling since the fourth quarter. The 30-year Treasury yielded as much as 3.46% in November. But the move picked up steam after the Federal Reserve’s July 31 rate decision, when the central bank disappointed many investors by not signaling a dramatic easing of monetary policy. The escalation of the U.S.-China trade war didn’t help. The 30-year yield has sunk 59 basis points in August, the steepest monthly decline since 2011.

As concerns grow over a global economic slowdown, the U.S. yield curve is sending an even louder recession signal. Two-year Treasuries yielded as much as 6.6 basis points more than the 10-year on Wednesday, the most deeply inverted this part of the curve has been since 2007.

Strategists as BMO Capital Markets said in a note Wednesday that there remains “ample” room for 30-year Treasury rates to move lower. “The momentum of buying can continue and has continued, even though there hasn’t been a big buying catalyst,” BMO’s Ben Jeffery said in a phone interview. “People still want to lock in yields even though they are lower.”

A practice known as convexity hedging, which has acted as a factor in depressing rates throughout the year, may also add fuel to the bond rally. When yields fall, the change in rates affects the duration of investors’ portfolios, and two sets of traders -- those who buy mortgage bonds and those who use derivatives to bet on market stability -- are acutely sensitive. To staunch losses, they often turn to interest-rate swaps, which in turn pushes Treasury yields down even more.

Evidence shows the technical phenomenon is still alive and well. While yields on 30-year Treasuries dropped as low as 1.90% on Wednesday, the rate on similar-maturity swaps got to 1.50%. The 30-year swap spread -- as the gap between the two measures is known -- sits near a two-year low.

Although investors in mortgage-backed securities might not be to blame for the latest moves, “other hedging flows are a major driver,” Cloherty said.

--With assistance from Ven Ram, Elizabeth Stanton and Vivien Lou Chen.

To contact the reporter on this story: Sarah Ponczek in New York at sponczek2@bloomberg.net

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

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