Treasury two-year yields reach highest since 2010 on Fed boost

by 18 Dec 2015
Yields rose across maturities after Fed officials lifted borrowing costs by 0.25 percentage point. Policy makers signaled a gradual approach to additional rate increases amid tame U.S. inflation.
“The Fed has an optimistic outlook for the economy and inflation, and it will be gradual,” said Gary Pollack, who manages $12 billion as head of fixed-income trading at Deutsche Bank AG’s Private Wealth Management unit in New York. “It’s going to keep the market on its toes for the foreseeable future.”

Two-year note yields rose by four basis points, or 0.04 percentage point, to 1.003 percent at 5 p.m. in New York, according to Bloomberg Bond Trader prices, climbing above 1 percent for the first time since 2010. The 0.875 percent note due November 2017 fell 2/32, or 63 cents per $1,000 face value, to 99 3/4.

Unanimous Vote

The yield on the benchmark 10-year note climbed three basis points to 2.3 percent, the highest since Dec. 3. It reached a 2015 peak of 2.5 percent on June 11. Ten-year notes are more sensitive than shorter-dated securities to economic forces such as growth and inflation.

The Federal Open Market Committee unanimously voted to set the new target range for the federal funds rate at 0.25 percent to 0.5 percent. Policy makers separately forecast an appropriate rate of 1.375 percent at the end of 2016, the same as September, implying four quarter-point increases in the target range next year, based on the median number from 17 officials.

“The committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective,” the committee said in a statement following a two-day meeting in Washington.

“The risks they claim are still balanced and it will be gradual, and lower rates will be prevailing for quite some time,” said Richard Schlanger, a money manager at Pioneer Investments in Boston, which oversees $30 billion in fixed- income securities. “It’s going to be more data-dependent.”

Crisis Legacy

The Fed’s move ends an era of extraordinary policy accommodation since it dropped rates near zero in December 2008 amid a financial crisis triggered by the housing-market collapse. The central bank also began the first of three rounds of bond purchases that year, starting with mortgages before adding Treasuries to the mix in March 2009. In total, policy makers approved $4 trillion in debt purchases.

The Fed on Wednesday said it will continue reinvesting principal payments from its holdings of mortgage bonds and rolling over maturing Treasuries at auction. The central bank said it expects to do so “until normalization of the level of the federal funds rate is well under way,” saying the policy “should help maintain accommodative financial conditions.”

Treasuries have earned an annualized 2.5 percent since December 2008, Bank of America Merrill Lynch indexes show. The Standard & Poor’s 500 index generated average annual returns of about 15 percent in that period, including reinvested dividends.

Policy Rate

With the Fed target at zero and Europe’s sovereign debt crisis worsening, the benchmark 10-year Treasury yield set a record low of 1.379 percent in July 2012. The yield has averaged about 4.1 percent since 1995, data compiled by Bloomberg show.

Job growth surpassed consensus forecasts the past two months, bolstering confidence that the economy was strong enough to withstand higher borrowing costs and leading traders to ramp up bets that Treasuries would fall. Hedge funds’ bearish futures bets on two-year notes, the maturity most sensitive to Fed policy changes, were the most since October 2014 as of last week.

The Fed last raised its policy rate in June 2006, to 5.25 percent. It was the 17th consecutive quarter-point increase and left the two-year yield at 5.18 percent, about even with the 10- year yield -- a flat yield curve, in the parlance of bond traders.

Borrowing Benchmark

Traders have latched on to the flattening trade again in 2015. With the Fed signaling a rate increase and inflation in check, investors have favored longer-dated Treasuries in recent months, driving their yields lower in comparison to shorter- dated obligations. The extra yield on 10-year notes over two- year maturities shrank to about 1.22 percentage points this month, the least since February.

The 10-year yield -- used to set rates on everything from car loans to mortgages -- began the year at about 2.2 percent amid projections it would climb to 3 percent by Dec. 31. Forecasters see the yield climbing to 2.75 percent at the end of 2016, according to the median prediction in the latest Bloomberg survey.

The bond market is pricing in an annual inflation rate of about 1.5 percent through 2025. Meanwhile, the inflation measure that Fed officials target rose 0.2 percent in October, short of their 2 percent goal.
Traders anticipate that the Fed will stick to a gradual pace of tightening, pricing in about a 41 percent probability that it raises rates by its March 16 meeting, based on the assumption that the effective fed funds rate will trade at the middle of the new FOMC target range after the next hike.

Bloomberg News
Daniel Kruger


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