U.S. Government Bonds Stronger on Fed Signals

The U.S. government bond market strengthened Thursday for a second consecutive session as investors cheered on the Federal Reserve's signals that its tightening campaign would continue to proceed in a slow manner to avoid rattling markets.

The yield on the benchmark 10-year Treasury note settled at 2.254%, compared with 2.266% Wednesday and 2.285% Tuesday. Yields fall as bond prices rise.

The haven bond market strengthened along with higher stocks, which mirror market moves driven by the Fed's bond buying monetary stimulus. The S&P 500 stock index hit a fresh record high during Thursday's session and deepened its rally this year.

Some traders say the prospect of steady bond yields continues to drive some investors to dial up risk spectra, which has been one of the factors fueling strong demand for stocks, corporate bonds and emerging market assets this year.

The Bank of America Merrill Lynch MOVE index, which measures implied Treasury bond price swings based on options, pointed to subdued expectation over price swings. The index settled at 54.4058 Wednesday, the lowest level since August 2014, another sign the Fed minutes released Wednesday afternoon reduced fears over a big rise in yields.

The Fed's minutes for its May 2-3 policy meeting suggest the central bank is on track to raise short-term interest rates next month. But officials signaled they may hold steady if economic conditions don't warrant a move so soon.

In addition, Fed officials suggested a slow and predictable manner when they start the process of winding down its large balance sheet which includes more than $2 trillion worth of Treasury bondholdings.

Traders and money managers say the release reassures investors that the central bank would try to avoid a repeat of the "taper tantrum". U.S. Treasury bond yields soared in 2013 as fears that the Fed would soon dial back bond buying spooked sentiment. Higher yields rippled broadly into corporate debt and emerging markets, causing a record pace of outflows from bond funds, tightening financial conditions and undercutting the U.S. growth momentum.

"The risk of another taper tantrum is fairly low," said John Bellows, portfolio manager at Western Asset Management Co. "The Fed doesn't want to disrupt the economic recovery. The Fed doesn't want to disrupt markets."

Lower bond yields also reflect a camp of thoughts in the bond market that after a possible hike in June, the Fed may stand pat for the rest of the year, say some analysts.

This explained why the bond market didn't sell off even as financial derivatives linked to bets on the Fed's policy outlook priced in a large probability that the Fed would pull the trigger at its June 13-14 meeting.

The idea runs against the Fed's projections in March about two additional hikes following the March move. Yet some investors say the Fed may be forced to pause given the uncertainty surrounding the outlook for the U.S. growth momentum, inflation and fiscal stimulus.

The consumer-price index excluding food and energy last month fell below the Fed's 2% target. Matt Toms, chief investment officer of fixed income at Voya Investment Management, said further signs of slowing inflation could derail the Fed's rate increase plan.

The 10-year Treasury yield has fallen this year after a big rise in late 2016. The yield traded at 2.446% at the end of 2016. In mid-March, it had traded above 2.6%.

Michael Collins, senior portfolio manager at PGIM Fixed Income, said if the 10-year Treasury yield rises above 2.5%, it would be a buying opportunity.

Traders say the range bound mentality in the bond market underscores the difficulty to predict bond yields given the conflicting signals in both the global economy and financial markets.

Leading into the year, the consensus trade was to bet that bond yields would extend the rises in late 2016. But the 10-year yield has fallen this year, causing hedge funds and money managers to either unwind or pare back wagers on higher yields. With higher yield bets no longer a crowded trade, it also reduces the risk of a big drop in yields unless the stock market suffers a big selloff, say analysts.

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

(END) Dow Jones Newswires

May 25, 2017 15:50 ET (19:50 GMT)