‘Volatility vortex’ slams into $24tn US government bond market

The $24 trillion US Treasury market has been hit by its most severe turbulence since the coronavirus crisis, highlighting how wide swings in international bonds and currencies and jitters over US interest rate hikes have deterred investors.

The Ice BofA Move Index, which tracks the volatility of the fixed income markets, has reached its highest level since March 2020, a time when deep uncertainty about the impact of the pandemic on the global economy caused massive swings in US Treasury bonds.

“Right now it’s all about market volatility,” said Gennadiy Goldberg, strategist at TD Securities. “You have investors who stay away because of the volatility – and investors who stay away increases the volatility. It’s a vortex of volatility.”

The nerves of fixed income investors have been frayed by a series of events most often observed during market crises. Japan, the world’s third largest economy, intervened last week to defend the yen after the currency plunged rapidly to a 24-year low against the dollar. Just days later, plans for major tax cuts by the UK government sparked a historic sell-off in UK currency and sovereign debt markets.

These international events contributed to a powerful slump in the US Treasury bond market, which accelerated after the Federal Reserve delivered its third consecutive 0.75 percentage point rate hike last week and signaled a significant tightening of monetary policy.

Ten-year government bond yields, a key measure of global borrowing costs, rose to nearly 4 percent from 3.2 percent at the end of August, heralding the largest monthly increase since 2003. ever annual increase. The two-year yield, which is more sensitive to US monetary policy fluctuations, has risen by 3.55 percentage points this year, which would also mark a historic increase.

The large price movements have left investors wary of trading in a market that is the bedrock of the global financial system and commonly considered a refuge in times of stress.

With investors on the sidelines, liquidity in the Treasury market — the ease with which traders buy and sell — has deteriorated to its worst level since March 2020, according to a Bloomberg index. Poor liquidity tends to exacerbate price swings, worsening volatility.

In a sign of how the difficult environment is keeping some fund managers away, the US has seen moderate demand this week in sales for a combined $87 billion in new debt.

A two-year issue on Monday with a high yield of 4.29 percent, and a five-year deal a day later with a price of 4.23 percent — both are the highest borrowing costs for the government since 2007.

The two-year debt sold with the biggest gap – or “tail” – between what was expected just before the auction and where it was actually priced since the Covid-induced market tug-of-war in 2020, said Tom Simons, a money market economist at US investment bank Jefferies.

The Treasury Department will auction $36 billion worth of bonds with a maturity of seven years on Wednesday. The seven-year note struggles to attract demand at less volatile times, so the environment could be challenging this week.

“Until there is more certainty, I think we will continue to have this ‘buyer strike’,” Simons said. “The markets are so crazy it’s hard to set new prices” [longer-dated bonds] come on the market.”

A divergence between the Fed’s own interest rate outlook and market expectations has increased the feeling of uncertainty.

According to their latest forecast, most Fed officials now expect Federal Funds interest rates to rise from its current target range of 3-3.25 percent to 4.4 percent by the end of the year. By the end of 2023, Fed officials expect interest rates to reach 4.6 percent.

Meanwhile, investors are betting that the Fed will be forced to cut interest rates next year — with the futures market forecast to peak at 4.5 percent in May 2023, before falling to 4.4 percent by the end of the year.

Given ongoing and broad-based price pressures, there is significant uncertainty as to whether that degree of monetary tightening will be enough to bring inflation back to the Fed’s 2 percent target. Recession risks have also increased significantly, further clouding the outlook.

Fed officials’ strong rhetoric about the central bank’s fight against inflation has further alarmed the market. Many officials now agree that interest rates should rise to levels that actively constrain the economy and stay there for an extended period of time.

“The only other time I have seen us so united was at the beginning of the pandemic, when we knew we had to act boldly to support the economy during the pandemic and during the downturn,” said President Neel Kashkari of the Fed’s Minneapolis branch, Tuesday in an interview with the Wall Street Journal.

“We are all united in our task of bringing inflation down to 2 percent, and we are committed to doing what we need to do to make that happen.”