Treasurys Stumble Again Amid Foreign-Demand Worries

By Daniel KrugerFeaturesDow Jones Newswires

Investors grappled Wednesday with the spreading ripples from a selloff in U.S. Treasury debt, reflecting expectations that higher bond yields will affect everything from asset prices to mortgage rates.

The yield on the benchmark 10-year U.S. Treasury note, which rises as bond prices fall, approached its 52-week closing high of 2.609% early in Wednesday's session, before paring its gains and settling higher for the fifth time in the past six trading days. Bank stocks soared, as rising yields tend to boost lenders' profits, while high-dividend stocks fell as their payouts faced greater competition from bonds.

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The 10-year yield is a critical benchmark for global finance, influencing everything from borrowing costs to demand for riskier assets, such as stocks. For years, investors and analysts have expected a rise in yields, long depressed by extraordinary stimulus measures adopted by central banks after the financial crisis.

If inflation is behind the rise in yields, "it could change the relationship between stocks and bonds," said James Bianco, head of the Chicago-based advisory firm Bianco Research. Inflation poses a threat to the value of long-term government bonds because it erodes the purchasing power of their fixed payments, while also depressing the value of corporate earnings over time.

Concerns about foreign demand for Treasurys spurred the latest bout of selling, as central banks from Europe to Asia signal that they may be preparing to scale back stimulus. The Bank of Japan surprised markets Tuesday by reducing the amount of its bond purchases by 5%, after the European Central Bank began the year by lowering its monthly buying to EUR30 billion from EUR60 billion.

Fresh selling began Wednesday after reports that Chinese officials have recommended reducing or stopping purchases of U.S. Treasury debt. The 10-year yield rose sharply, reaching as high as 2.597%, according to Tradeweb, then pared those gains after robust demand for the debt at the U.S. government's afternoon auction of $20 billion of 10-year notes.

Analysts and investors questioned whether China has a suitable alternatives to Treasurys, given the size of their reserves. Several said the comments could signal criticism of recent sweeping tax cuts, which are projected to raise deficits by more than $100 billion annually through 2027, or as a warning to President Donald Trump before the next round of trade negotiations between the U.S. and China.

The benchmark Treasury 10-year yield rose to 2.551% Wednesday, its highest closing level since March 14, from 2.542% Tuesday.

"If China really wanted to move its reserves around for financial reasons, they'd keep it quiet," said Brad Setser, a senior fellow at the Council on Foreign Relations and a former senior U.S. Treasury official in the Obama administration.

China typically maintains about 40% of its reserves in Treasury debt, and with $1.2 trillion of U.S. government debt is near that level, given $3.1 trillion in reserves, Mr. Setser said. Should reserves remain stable, there would be no reason for China to add more bonds anyway, he said. The eurozone is also a bigger buyer of U.S. fixed income these days than China, he added.

Whichever factor pushes yields upward, investors said higher Treasury yields may prompt a re-examination of the competing valuations of stocks versus bonds. That could attract a cohort of aging individual investors, who invest in fixed-income as part of retirement-savings strategies, said Jack McIntyre, who manages global bond portfolios at Brandywine Global Investment Management.

Investors on Wednesday sold shares of utilities and real-estate companies. Known as bond proxies because they typically pay hefty dividends, the two sectors tend to become less appealing when bond yields rise. Shares of real-estate companies in the S&P 500 fell 1.5% Wednesday, while shares of utilities lost 1.1%, making the two sectors the biggest decliners in the index.

The KBW Nasdaq Bank Index of large U.S. commercial lenders rose 1.3% even as the S&P 500 declined. Rising interest rates tend to boost bank profits by increasing the gap between what they pay on deposits and charge on loans, a spread known as the net interest margin.

Another lift to bank shares could come from the abrupt widening of the gap between the yields on two- and 10-year Treasurys. That spread, known as the yield curve, a has increased to 0.58 percentage point from as low as 0.497 percentage point earlier this month. The gap had begun 2017 at 1.25 percentage point. A steepening yield curve can also boost lenders' profits, because they typically borrow short term and lend long term.

Some analysts said the selling was unlikely to push the benchmark 10-year Treasury yield to 3%, a level last seen in December 2013. At those heights, investing in a high-dividend stock becomes less attractive compared with bonds' relative stability and reliable coupon payments.

Demand from individual investors and questions about the Fed's commitment to its current pace of interest-rate increases could cap yields for some time, some analysts said.

"Investors will be looking back in three, six, nine months and saying it wasn't a bad idea to be maintaining or increasing bond exposure," said Robert Tipp, chief investment strategist at PGIM Fixed Income.

Write to Daniel Kruger at Daniel.Kruger@wsj.com

(END) Dow Jones Newswires

January 10, 2018 18:04 ET (23:04 GMT)