Treasuries managed to escape yesterday’s session relatively unscathed despite the FOMC’s announcement of the first reduction in the pace of the Federal Reserve’s quantitative easing program (a.k.a. “tapering”) a few months before most on the Street expected.
Today, however, U.S. government bonds are taking a hit.
The belly of the curve — which refers to Treasuries maturing in 5 to 7 years — is taking the brunt of the damage (see Chart 1 below). It’s considered the most richly-valued portion of the curve, and is most sensitive to changes in Fed policy, as a large portion of the Fed’s portfolio is concentrated in the belly.
“We wrote up our post views last night and concluded that the front end of the curve and belly would suffer,” says David Keeble, head of fixed income strategy at Crédit Agricole. “This momentum appears to be building this morning.”
Gennadiy Goldberg, a strategist at TD Securities, agrees with that assessment.
“I think the market finally realised that tapering is here and that lower purchases by the Fed will weigh quite significantly on Treasuries,” says Goldberg. “The long-end (10s and 30s) was substantially better positioned for tapering than the belly of the curve, and that is where we are seeing most of the selling, which has flattened the curve. I think the belly of the curve is a bit disappointed with the vague forward guidance provided by the Fed (no set target past 6.5% unemployment) and is cheapening because of that.”
Goldberg also notes that yesterday’s auction of 5-year notes was weak, and today’s auction of 7-year notes is “putting further pressure on the curve.”
10-year U.S. Treasury futures are down 0.5% from yesterday’s close. Tom di Galoma, head of rates trading at ED&F Man Capital Markets, notes that 50,000 contracts — $US3 billion of 10-year equivalents — traded around 8:48 AM ET, indicative of a big seller in the market.
Meanwhile, at the front end of the curve, traders are pulling forward expectations for when the Fed will hike rates from current levels between 0 and 0.25%, where they’ve been since the financial crisis.
Eurodollar contracts, which reflect the future expected yield on 3-month dollar deposits outside the U.S., are selling off, causing those yields to rise. Chart 2 shows the change in the eurodollar curve from yesterday’s levels.
Yesterday, Fed chairman Ben Bernanke said in a press conference following the FOMC decision that the Fed had “enhanced” its forward guidance on the future path of short-term interest rates by specifying that the FOMC would not hike rates until “well past” the unemployment rate hits 6.5%, the current threshold the central bank has said must be met before it considers hiking rates.
“The Fed’s own forecasts for higher inflation suggest that the new guidance will unlikely be a hard constraint upon hiking rates and that the Fed’s unemployment rate forecasts are seen hitting the hard limit of 6.5% by the end of the year,” says Keeble. “Additionally, by stressing that the pace of the taper is heavily data dependent, the Fed curtailed the market’s ability to re-establish the carry trade.”
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