A Bond-Investing Conundrum Returns

By Min ZengFeaturesDow Jones Newswires

The U.S. bond market is defying the Federal Reserve again.

The central bank has raised short-term interest rates four times beginning in December 2015 and pushed up the key policy rate by one percentage point. Yet the yield on the benchmark 10-year Treasury note settled at 2.198% on Tuesday, below the 2.269% where it settled before the Fed's first rate increase since 2006. Yields fall as bond prices rise.

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The tension reminds some investors of the "conundrum" described by Alan Greenspan, then Fed chairman, in February 2005. Mr. Greenspan was puzzled by long-term Treasury yields that were ticking lower despite increases in the federal-funds target rate.

"I think it's part of the same conundrum, maybe just a bond-market conundrum redux," said Michael Collins, senior portfolio manager at PGIM Fixed Income.

Resolving that quandary is key to investors and Fed policy makers because of concerns the central bank's moves to normalize interest rates could dent the economic expansion, already the third longest in U.S. history. Some worry it could also affect asset-allocation strategies at a time when many are concerned that stock valuations could be stretched.

If low interest rates push investors into excessive risk-taking, the Fed may need to tighten monetary policy more drastically, a scenario that could cause a sharp pullback in stocks and other riskier assets and raise the threat of a U.S. recession, some investors said.

Recently, Eric Rosengren, president of the Federal Reserve Bank of Boston, said that the era of low rates in the U.S. and elsewhere poses financial-stability risks. And Fed Vice Chairman Stanley Fischer said the world "cannot afford another pair of crises of the magnitude of the Great Recession and the global financial crisis."

Fed officials don't want to see a sharp rise in bond yields either, some analysts said. The 10-year Treasury yield is a benchmark for global finance, so a big rise would push up long-term borrowing costs for consumers and businesses and tighten financial conditions sharply, a scenario central bankers are trying to avoid, several said.

The Fed's conundrum is partly a result of investors' confusion about how to respond to the central bank's plans, which also include paring back its large balance sheet later this year.

Yields have risen on short-term government debt, which is more sensitive to the central bank's policy outlook. But yields on long-term debt are influenced by a variety of factors, including the economic and inflation outlook in both the U.S. and abroad.

In previous tightening cycles, a popular trade was to sell short-term debt and put money into long-term bonds, betting on the gap between the two yields to fall, which is known as a flattening yield curve. The 10-year Treasury's premium relative to the two-year note is trading near the lowest level since 2007.

But some investors are concerned that this trade may be getting crowded and could be vulnerable to a reversal if the Fed surprises investors with an aggressive approach in unwinding its balance sheet.

That balance-sheet reduction could push up the term premium for the 10-year note, say some analysts and investors. The term premium is the extra compensation investors demand to hold the 10-year Treasury note instead of buying a series of shorter-term debt over the next 10 years.

The premium has fallen below zero since March, a sign of heightened demand for the 10-year note. The premium traded at around negative 0.4% on June 23, according to the latest data from the New York Fed's website, near a record low of negative 0.77% in July 2016, when the 10-year yield closed at a record low of 1.366%.

Some money managers said the Fed's slow and cautious approach could reduce the chances of a repeat of the 2013 "taper tantrum," when the bond market was spooked by then Fed Chairman Ben Bernanke's comment in May 2013 over a possible cut in bond purchases.

Several said they planned to wait for the actual implementation of the Fed's balance-sheet reduction before making wagers on the yield curve.

"The old playbook may not work," said Jason Evans, co-founder of hedge fund NineAlpha Capital LP.

Write to Min Zeng at min.zeng@wsj.com

(END) Dow Jones Newswires

June 27, 2017 19:25 ET (23:25 GMT)