The yield on the 1-year Treasury is testing 4%, a level that traders say could spill over to other rates and send shivers through financial markets, as the Federal Reserve continues in earnest with its campaign to reduce its balance sheet by $8.8 trillion. .
This balance sheet process, known as “quantitative tightening,” is intended to complement the central bank’s series of aggressive rate hikes, one of which is expected to arrive next Wednesday. The Fed is now “tightening on all cylinders” as the “training wheels” come off QT after a slow start, according to BofA Securities rate strategist Mark Cabana. And traders say that’s one of the reasons behind moves in the one-year yield on Thursday, which included intermittently touching or going slightly above 4% before falling back again.
“Four percent is a magic number and one that scares many asset markets, including stock markets, and pretty much everyone,” said chief trader John Farawell at Roosevelt & Cross, a bond underwriter at New York. The Fed’s QT process is one of the reasons this is happening and “adds pressure to the beginning of the curve.”
A 4% yield is likely to spill over to other rates in the Treasuries market as expectations solidify around the Fed’s aggressive rate moves, Farawell said by phone Thursday. “You can see more or less the same thing you’re seeing now – more stress in the equity market – and you can see equity investors exiting.”
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Indeed, the three main American indices DJIA,
ended lower on Thursday as Treasury yields continued to climb.
Data provided by Tradeweb shows that the one-year rate TMUBMUSD01Y,
went slightly above 4% three times during the morning and afternoon in New York, before falling back.
The one-year yield, which reflects expectations about the Fed’s short-term policy path, hasn’t ended the New York trading session above 4% since Oct. 31, 2007, according to FactSet.
Meanwhile, the bond market gave more worrisome signals about the outlook: the spread between 2- and 10-year Treasury rates fell to minus 41.3 basis points, while the spread between 5 and 30 years narrowed to minus 19.3 basis points.
Financial market participants have slowly rallied around the idea that the Federal Reserve will continue to tighten financial conditions until something breaks in the US economy, in order to curb the hottest period of inflation in recent years. last four decades.
Besides QT, other reasons for the one-year yield trend towards 4% are that traders are increasingly focused on the level at which policymakers will end rate increases, known as the terminal rate. , and there is concern that one of the Fed’s next moves could be a giant 100 basis point hike, according to a strategist.
Higher rates, particularly in the one-year Treasury, benefit investors who haven’t yet had a chance to enter the fixed income market, giving them a chance to earn higher yields at a lower price. “We could see investors turn to the safety of Treasuries and see more players enter the bond market. Treasury bills could become a viable option for some people,” Farawell of Roosevelt & Cross told MarketWatch. He noted that the 1-year Treasury rate has been “fractional,” or close to zero, between 2020 and the start of this year.
When policymakers flooded the markets with liquidity in the era of easy money, through the process known as quantitative easing, equities were seen as one of the main beneficiaries. So it makes sense that the reverse process – quantitative tightening – and its acceleration could hit equities harder.
This month, the Fed’s maximum pace of balance sheet reduction increased to $95 billion a month in Treasuries and mortgage-backed securities, from $47.5 billion the previous month. According to BofA’s Cabana, this increasing pace of QT will put more Treasuries and mortgage-backed securities into private hands, create aggressive competition among commercial banks for funding, and result in higher borrowing costs.
QT’s impact to date “has been minimal,” Cabana wrote in a note Thursday. Over time, however, this should ultimately result in “higher funding rates, tighter financial conditions and headwinds on risky assets.”
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Still, traders felt that the Fed’s QT pace acceleration was already having an impact.
“There is a psychological impact to reaching 4% on the 1-year yield – which has the potential to spill over to other overseas capital markets,” said Larry Milstein, senior managing director of trading at the public debt at RW Pressprich & Co. in New York. “People are now realizing that the Fed is going to have to stay higher for a long time, inflation is not coming down as fast as expected, and the terminal rate is going up.”
“For a long time people were talking about TINA, but you don’t necessarily have to be in the stock market to get a return,” Milstein said over the phone. TINA is an acronym used by traders for the idea that “there is no alternative” to stocks.
Like Farawell, Milstein sees more investors taking money out of stocks and putting it into shorter-term Treasuries.
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