By Peter Bergman (MoneyAmped.com)
Concerns are emerging in the market regarding bonds as fiscal worries resurface, and the expectation of lower inflation leads to speculation about potential interest rate cuts by the Federal Reserve in the near future.
Investors Wait for Fed Discount Rate Cut and Believe In Bond Growth
Optimistic investors anticipate that the strong upward trend in bonds witnessed towards the end of 2023 will likely persist into the current year, provided that the Federal Reserve eases its monetary policy as anticipated.
Investors are currently expecting significant cuts in the Fed’s primary policy rate, with futures indicating a projection of over 150 basis points. This exceeds the amount policymakers had previously projected.
Hold on, caution the bears. Although expectations for Fed easing are currently influencing bond prices, some believe that the increase in U.S. Treasury issuance, projected to reach $2 trillion in 2024, could serve as a balancing factor.
Experts argue that in order to attract demand for the influx of new debt, yields – which have an inverse relationship with bond prices – would need to increase from their current levels. These concerns played a significant role in pushing Treasury prices to their lowest point in 16 years during the heightened period in October.
Significant Decline in Treasury Bond Prices
Thus far, there has been a noticeable beginning-of-the-year decline in treasuries, as productions on the standard 10-year treasury have risen by 16 percentage points from their lows in December.
There has been a significant increase in opposing positions on specific long-term Treasury periods in the futures marketplace, reaching the highest level since October, according to data from the Commodity Futures Trading Commission.
“There is a significant amount of U.S. Treasury supply resulting from the lack of fiscal discipline in this country, and it is unclear who the buyers are,” commented Chris Diaz.
According to him, the longer-dated maturities are more susceptible to fiscal concerns, which could pose a significant challenge for the long end of the market to sustain its rally.
According to a survey conducted by BofA Global Research, 23% of investors expressed strong confidence in betting on lower Treasury prices as their top trade for 2024. Similarly, 21% of investors held the same conviction for betting on higher Treasury prices.
The bank’s analysts wrote on Friday that this marked a significant shift from their previous optimistic predictions on bonds.
Concerns regarding the sustainability of U.S. debt intensified last year, as a credit rating downgrade by Fitch and increased Treasury issuance plans led to a bond selloff. This resulted in the 10-year yield reaching its highest level since 2007, surpassing 5%.
Investor attention was drawn to the measure of term premiums – the extra compensation bondholders require for the risk of holding long-term debt – which became optimistic in September for the initial time in two years. This was due to the decline in bonds.
Bond prices experienced a reversal in the final weeks of 2023 due to the increasing expectations of a more accommodative stance from the Federal Reserve. However, confident investors are of the opinion that bonds might have already taken into account potential decreases in interest rates, which could leave them exposed if fiscal worries resurface.
“As we approach 2024, the level of Treasury issuance will be of utmost importance, particularly in terms of finding buyers for that paper,” commented Tony Roth, the director of investments at Wilmington Trust. According to Roth, the situation could become more complex if there are indications that inflation is more persistent than anticipated. This is because inflation reduces the worth of future bond payments, making real yields less appealing.
Who Will Come To the Rescue?
A number of these concerns may be alleviated by the Federal Reserve’s reentry into the Treasuries market, which could assist in managing the increase in long-term yields.
Starting in June 2022, the Fed has been actively reducing its balance sheet by over $1 trillion. This is a deliberate move to reverse the large-scale bond purchases made by the central bank in 2020 to stabilize the markets during the COVID-19 pandemic.
However, certain Federal Reserve officials have recently suggested that it may be prudent for the central bank to begin contemplating a reduction and eventual cessation of its bond holdings contraction.
Last week, JPMorgan analysts noted that an accelerated conclusion to quantitative tightening may have a positive impact on the supply-demand dynamics in the Treasury market. This would result in a decrease in the number of government bonds being sold to the private sector.
The end of the balance sheet runoff may result in duration rallying and provide some additional support for 10- and 30-year Treasuries, according to Pramod Atluri, an income portfolio strategist at Capital Group.
The market could see a shift in Treasury issuance as the Fed returns, leading to a larger share of longer-term debt securities being sold after their sales were limited in recent months.
“If the Fed resumes purchasing bonds, perhaps the Treasury can return to issuing more conventionally,” commented John Luke Tyner, an investment researcher at Aptus Capital Advisors. “The Federal Reserve can absorb a portion of those bonds.”
