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Analysis: U.S. Treasuries rout may be far from over

The sun rises to the east of the U.S. Federal Reserve building in Washington, July 31, 2013.REUTERS/Jonathan Ernst
The sun rises to the east of the U.S. Federal Reserve building in Washington, July 31, 2013.REUTERS/Jonathan Ernst

By Luciana Lopez and Jennifer Ablan

NEW YORK (Reuters) - It has already been a horrid year for investors in U.S. Treasuries - and it could easily get much worse.

U.S. government bonds ended August with their fourth straight monthly loss, down 3.43 percent on a total return basis in the four months, their worst such stretch since 1996, according to the Barclays Aggregate U.S. Treasury Index <.BCUSATSY>.

Yields on benchmark 10-year Treasury notes have surged by 1.29 percentage points since their low-water mark around 1.6 percent in early May. But even at 2.89 percent on Wednesday, yields could move even higher, and prices lower, when the U.S. Federal Reserve pulls back on its $85-billion-a-month buying of Treasuries and mortgage-backed securities, a process largely expected to begin with the September 17-18 meeting of the Federal Open Market Committee.

"I don't know what the magic number is, but Treasury yields will be much higher than they are now by year-end," said Dan Fuss, vice chairman and portfolio manager at Loomis Sayles, which has $190 billion in assets.

Altogether, there is plenty of scope for 10-year yields not just to breach the psychologically key 3 percent barrier - a level unseen since July 2011 - but to overshoot and notch further multi-year highs in coming months.

This matters because U.S. government debt is used as a benchmark for pricing a huge range of other interest rates, from home mortgages to complex derivatives around the world.

The Fed's purchases have swollen its balance sheet to a record $3.6 trillion, but the Fed isn't looking to stop its buying just because it owns so much of the market.

By several measures, the U.S. economy is picking up steam, meaning the Fed doesn't need to prop up the economy as much. Growth in U.S. home prices and manufacturing orders, including robust auto sales, have been among the positive economic signs. Jobs growth has been solid, though unspectacular.

Price pressures could also speed up, potentially prompting the Fed down the road to pay more heed to the inflation half of its dual mandate of promoting maximum employment and stable prices.

Historically speaking, yields continue to be quite low. As recently as 2007, benchmark yields rose above 5 percent.

"The market has underestimated the risk that inflation pressure actually may not continue subsiding and may even turn around," said Pippa Malmgren, president of Principalis Asset Management, who advises investors on policy and political risk. She pointed to price pressures in emerging markets that could bleed into industrialized countries.

Recent inflation data was strong enough to prompt even some longtime inflation bears to throw in the towel.

"I've been in the deflation camp for two decades ... but strongly feel it is time to move on," said David Rosenberg, chief economist and strategist of Gluskin Sheff and Associates, to clients last month.

While worries about a potential U.S. military strike against Syria took yields off their two-year highs recently, Treasuries are selling off again now that such action has been delayed.

An unexpectedly long engagement in Syria could rekindle a bid for Treasuries. And should another standoff between the White House and Congress over raising the debt limit roil other markets, Treasuries could benefit from a flight to safety even against the risk of a technical default, as happened in 2011.

Still, it largely comes down to the Fed. With data pointing to an improving jobs market and faster second-quarter growth, some Fed speakers say it is time to wean the economy off the bank's substantial help.

Most economists in a Reuters poll see tapering of the bond buying program starting at the bank's meeting later this month.

MORE THAN JUST TREASURIES

The weakness has not been limited to government bonds. More broadly, with corporate debt and mortgage-backed securities, this year has been the worst for bonds on record, with the Barclays U.S. Aggregate Bond Index <.BCUSA>, the most widely tracked bond market benchmark, down 3.2 percent to date on a total return basis. If it doesn't improve over the rest of the year, that decline will exceed the previous worst year in the index's 40-year record, which was in 1994 with a loss of 2.9 percent.

And investors, from big institutional funds to sovereign accounts, are not waiting for a turnaround. According to data from Lipper, a Thomson Reuters unit, taxable bond funds have seen outflows four of the past five weeks.

The Pimco Total Return Fund, the world's largest bond fund, had $7.7 billion in net cash outflows in August, marking the fourth straight month of withdrawals, according to Morningstar.

The DoubleLine Total Return Bond Fund , meanwhile, had $1.13 billion in estimated outflows in August, marking its third straight month of withdrawals.

China and Japan led the Treasuries exodus in June. Those two countries accounted for almost all of a record $40.8 billion of net foreign selling of Treasuries.

And speculators increased their net bearish bets on U.S. 10-year Treasury note futures in the latest week to the highest level in more than a year, according to Commodity Futures Trading Commission data.

Thin liquidity will also exacerbate sharp bond market moves, said Fuss at Loomis Sayles. With markets structurally thinner in an environment of rising rates, the bond market will be erratic.

Certainly some large fund managers see further losses being limited, with another 1-percentage-point, or 100-basis-point, rise in yields unlikely.

Markets "react to surprises," said Jeff Rosenberg, chief investment strategist for fixed income for BlackRock, and so tapering expectations are now largely baked into prices.

Invesco has already shed significant Treasuries exposure.

"We literally had 25 percentage points lower bond exposure this year than we did in years past," said Scott Wolle, chief investment officer of Invesco's global asset allocation team and principal manager of the Invesco Balanced-Risk Allocation Fund.

But funds still stuffed with Treasuries could be in trouble. Risk-parity funds, for example, try to balance risk among asset classes. Those funds are often overweight government debt.

That makes them vulnerable, said Diane Garnick, chief executive of Clear Alternatives, an asset management firm in New York.

"People are underestimating the implications for risk parity as the Federal Reserve begins to taper."

(Reporting by Luciana Lopez and Jennifer Ablan; Additional reporting by David Gaffen and Sam Forgione; Editing by Dan Burns, Martin Howell and Tim Dobbyn)

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