Why did Treasuries suddenly sell off?
Optimism around encouraging vaccine efficacy data, the prospect of increased economic growth and an impending round of fiscal stimulus set the stage for an astonishing sell-off in longer-dated US Treasuries. Weak demand conspired with fear and illiquidity to boost the 10-year yield by as much as 22bp intraday, ultimately closing up 14bp at levels not seen in a year.
The Treasury held several auctions this week, against this difficult demand backdrop. The 5-year Treasury auction earlier in the week showed signs of softer demand, which was not particularly surprising, given the market momentum. Yesterday's 7-year auction result was worse — one of the weakest for any maturity shorter than 10-years since 2009 — pricing with a 4bp concession.
Many Treasury market participants backed away shortly after these results were announced and a transient period of decreased liquidity exacerbated the negative market momentum. The yield on the benchmark 10-year Treasury briefly touched 1.60%, the highest level since February of last year, before eventually retracing some of that move and finishing the day at 1.52%.
Don't be mistaken – this is not another 'taper tantrum'
In our view, the Treasury market appears to be pricing in a more optimistic outlook on growth rather than a disruptive change in monetary policy. A chorus of Fed speakers this week, including Chairman Powell, reaffirmed the central bank’s commitment to accommodative monetary policy and asset purchases.
During the 'taper tantrum' back in 2013, the market believed that the Fed was about to cease its asset purchases. Additionally, then Fed Chair Ben Bernanke's term was expiring, and the market feared a more hawkish successor in Larry Summers before the more dovish Janet Yellen was eventually appointed.
We do not see a 'tapering' policy as a danger any time soon, considering Janet Yellen has just been appointed as Biden's Treasury Secretary, indicating the rising collaboration between the Treasury and the Fed which has already been increasing since the start of the pandemic.
Convexity hedging is not the technical headwind it used to be
Agency Mortgage Backed Securities (MBS) tend to rise in duration as interest rates rise (as mortgage prepayments tend to fall – lengthening the securities' expected lives). MBS holders often hedge this additional interest rate exposure through short Treasury positions.
We believe this was far less of a factor than in the past (during similar rate moves) because there is a lower proportion of market participants that engage in this behavior. Consider that the Fed alone now holds approximately a third of the Agency MBS market on its balance sheet, and it does not hedge the convexity of its portfolio.
Banking regulation may also be having a technical impact
At the end of March, the 'supplementary leverage ratio' requirement (which has allowed banks to exclude Treasuries holdings in its leverage calculations) will expire, increasing the capital expense of holding Treasuries. This may also be limiting banks' appetite to step in and buy Treasuries to take advantage of a steeper curve, thereby negating a typical shock absorber.
There is, however, a significant probability that the Fed will extend this relief to at least year-end, thereby allowing banks to more easily add to their holdings. Over the past year, commercial banks have increased their Treasury and agency holdings by $800 billion. A renewal would be a potentially sizable technical tailwind.
Not an inflation-based move
Although 'breakeven' market rates (the difference between nominal Treasuries yields and TIPS of equivalent maturities) have been pricing in higher future inflation since the start of the year, they actually fell yesterday (i.e. pricing in a lower implied rate of inflation at 10-years). This indicates the market was factoring in an improving growth story, not concerning levels of inflation.
Sharp short-term market moves tend to be driven by technical factors and / or emotional trading. We also believe they tend to be self-limiting over longer periods and often bring potential opportunities. We will continue to evaluate market moves such as these with a cool head, incorporating new information where relevant, while standing ready to take advantage of any potential opportunities we see.