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Bond-Market Tumult Puts ‘Lower for Longer’ in the Crosshairs

A series of Federal Reserve officials have said the climb is a healthy one, reflecting investors’ improving expectations for a vaccine- and stimulus-fueled economic recovery. Many portfolio managers say they believe rates are likely to flatten out in coming days as yields finally reach what they see as attractive levels.

But there are signs, such as unusually soft demand for recent Treasury debt auctions, that selling may not be over and yields may have further to rise. Some traders warn that bond markets are signaling a powerful economic recovery that could upend the dynamics that have held borrowing costs low while powering stocks to records.

The seven-year note was sold at a 1.195% yield, or 0.043 percentage point higher than traders had expected—a record gap for a seven-year note auction, according to Jefferies LLC analysts. Primary dealers, large financial firms that can trade directly with the Fed and are required to bid at auctions, were left with about 40% of the new notes, about twice the recent average.

The tepid demand concerned investors because the government is expected to sell a huge amount of debt in coming months to pay for the stimulus efforts that undergird the recovery. Further poor auction results could fuel additional selling in bond markets and undermine the tone in other markets, such as those for stocks, investors said.

The Fed’s rate cuts during the past year helped fuel a wave of home sales and refinancings, but the recent climb in yields drove mortgage rates to their highest level since November this past week, and applications have dropped. That forces banks and other holders, such as real-estate investment trusts, to sell Treasurys to offset losses in mortgage bonds that happen when consumers stop refinancing.

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Moves in market-based measures of inflation are also prompting concerns. Rising prices dent the purchasing power of bonds’ fixed payments and could force the Fed to raise rates sooner than expected. While inflation has remained muted for years, usually below the Fed’s 2% target, some worry that the economic reopening and stimulus efforts by the Fed and Congress could spark an acceleration. The five-year break-even rate—a measure of expected annual inflation over the next five years derived from the difference between the yields on five-year Treasurys and the equivalent Treasury inflation-protected securities—hit 2.4% in recent days, the highest since May 2011.

At the same time, the recent uptick in Treasury yields hasn’t only reflected increasing inflation expectations, as was essentially the case earlier in the year. Over the past two weeks, yields on Treasury inflation-protected securities—a proxy for so-called real yields—have also shot upward, with the 10-year TIPS yield rising from roughly minus 1% to minus 0.7%. That move has caught investors’ attention because many credit deeply negative real yields with helping power stocks to records, pushing yield-seeking investors toward riskier assets. Real yields were around zero percent or higher from the middle of 2013 through the start of 2020, meaning they might have more room to rise even after their recent move. 

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