The normally placid US Treasury market, often likened to a sleeping giant, is beginning to stir, and some investors fear this restlessness could soon spill over into other assets like equities in the coming days and weeks.
The next few weeks are expected to be a pivotal period for the $30 trillion US Treasury market, widely regarded as the cornerstone of the global financial system. Treasuries serve as crucial collateral for institutional short-term liquidity, while their yields set the benchmark borrowing rates for trillions of dollars in global debt, from mortgages to corporate bonds.
Long-term US Treasury yields rose steadily earlier this month before spiking sharply in the final week of July. Some interpret this move as a signal that the market believes the Federal Reserve is bluffing. Since taking the helm of the Fed, Chairman Kevin Warsh has maintained a hawkish stance on inflation. However, investors are beginning to doubt whether he and his colleagues on the central bank's rate-setting committee have the resolve to begin raising borrowing costs again, even as inflation has persistently exceeded the Fed's 2% target for five years.
On Wednesday, three members of the Fed's rate-setting committee, all regional Federal Reserve Bank presidents, broke ranks with their colleagues and voted in favor of a rate hike. "The market is questioning how determined the Fed is to control inflation," said Gennadiy Goldberg, head of US interest rate strategy at TD Securities.
By the time the dust settled on Friday, the yield on the 30-year Treasury bond had touched its highest level since 2007. Meanwhile, according to one analyst, the yield on the crucial 10-year Treasury note broke decisively higher, emerging from a trading range that had held since late 2023. In recent times, when Treasury yields have reached or approached these levels, stress has begun to spread to other markets, often dragging down stock prices.
The worrying nature of last week's rise in long-end yields was further highlighted by the diminishing correlation between yields and oil prices, as crude oil prices moved lower. Bob Elliott of Unlimited Funds wrote in a recent commentary, "It is difficult to know how long other asset markets, particularly equities, can withstand this level of interest rates without being dragged down."
As Chairman Warsh's press conference concluded last week, long-term Treasury yields staged a sudden upward breakout, while short-term yields moved lower. This caused a dramatic narrowing of the yield curve, the spread between short-term and long-term yields. According to an analysis by Dow Jones Market Data, it was the largest curve flattening on a "Fed Day" since 2023.
As traders scramble to hedge against the risk of further rate increases, the ICE BofAML MOVE index, a measure of expected volatility in the Treasury market, has climbed to its highest level since May. Data also shows that demand for put options on the iShares 20+ Year Treasury Bond ETF (TLT) has increased, pushing the put-to-call volume ratio higher. Analysts at Cboe Global Markets noted that the one-month TLT put skew, which measures demand for out-of-the-money puts relative to out-of-the-money calls, surged to its highest level since the 2008 financial crisis, indicating traders are preparing for more pronounced swings in the Treasury market.
Goldberg of TD Securities says this is not entirely surprising. "There is uncertainty surrounding Iran, some uncertainty regarding the Fed's policy guidance, and all sorts of other noise in the market right now," Goldberg commented.
Late last week, the US Treasury and the Federal Reserve, alongside Japanese authorities, conducted a historic coordinated intervention to help stabilize the weak and volatile Japanese yen. The US decision to join the intervention may have been motivated by a desire to prevent another violent eruption in the Treasury market.
Several key events in the coming days are expected to keep bond traders on high alert. More details on the US Treasury's latest funding plan are due later this week, and any surprises could trigger further volatility. Investors will also face a slate of crucial economic reports, with the July jobs report on Friday being the main event. "Our base case is no rate hike this year or next, but the probability of a hike has risen significantly," Goldberg added.
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