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 Stocks plunged in the second half of August, largely on fears of
China's worsening economy, but U.S. Treasury yields did not see the
kind of safety bid that many were expecting and has been typical in
times of stock-market stress in the past.
Strategists link the lack of a move to bonds to a number of events:
Hawkish rhetoric from Fed officials even as the equity market
stumbled; a bout of selling by hedge funds that had expected a rally
in the bond market that they didn't get; and bond sales by central
banks in China and other emerging market economies trying to protect
their currencies from depreciating.
Reduced appetite from overseas, along with the outlook for the Fed,
will be crucial in coming weeks if equities fall again and bonds
don't respond. The Fed decision on September 17 could mark the first
rate increase in almost a decade, and uncertainty surrounding that
decision is likely to keep many in the bond market on the sidelines.
"The correlation between bonds and stocks is more situational now
because it's the central banks calling the shots," said Robert
Vanden Assem, head of developed markets investment grade
fixed-income at PineBridge Investments in New York.
During the recent U.S. stock market sell-off in the third week of
August, for instance, the S&P 500 <.SPX> dropped 9 percent, but U.S.
10-year Treasury yields, which move inversely to prices, fell by
only 12 basis points.
That's not typical. According to Bank of America Merrill Lynch, the
relationship between stocks and bonds that has held since 2009
suggests 10-year yields should have declined by 22 basis points.
Bond yields since then have drifted higher and buying interest has
been minimal. The lack of a rally in the U.S. Treasury market made
big losers out of notable hedge funds, including Bridgewater
Associates' All-Weather Fund, which fell 4.2 percent in August.
These funds borrowed heavily to augment their returns, but as things
became turbulent, that leverage generated losses that forced them to
wind down that borrowing.
Strategists say part of what kept Treasury yields from reflexively
falling through a run to safe-haven debt were hawkish signals from
the Fed, particularly Fed Vice Chair Stanley Fischer.
At last week's central bank gathering in Jackson Hole, Wyoming,
several Fed officials, including Fischer, seemed to boost the odds
on a rate increase if not in September, then certainly in December.
The message the Fed delivered over the weekend came between a Friday
and Monday that saw the U.S. Standard & Poor's 500 lose 7 percent of
its value.
Leading brokerages, including Citigroup and Bank of America,
commented that though it's a close call, the odds favor an increase
in the next few weeks.
"Unless the U.S. economy shows signs of slowing, the bond market is
likely to keep yields relatively firm," said Alan Gayle, director of
asset allocation at RidgeWorth Investments, even if the S&P 500
falls in the weeks ahead on concern about growth in China and other
emerging market economies, he said.
Interest rate futures this week saw a more than 50 percent chance of
a rate hike in December and a 28 percent probability in September ,
according to CME Group's FedWatch program.
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If that happens, bonds won’t look as attractive. Higher interest
rates diminish the value of an investor's bond holdings, resulting
in lower portfolio returns.
"Treasuries have been a good diversifier to portfolios, but their
benefit as a diversifier has been reduced because yields are already
extremely low and the Fed is starting to normalize rates," said Rick
Rieder, chief investment officer of fundamental fixed income at
BlackRock in New York.
CHINA, CURRENCY INTERVENTIONS
Further supporting yields on U.S. Treasuries was the sell-off in
reserves by China and other emerging market economies to shore up
their slumping economies. U.S. Treasuries represent the bulk of the
Chinese and emerging market reserves.
Fears over weakened growth prospects and plunging commodity prices
in some emerging markets have taken a toll on their currencies. As
China sold currency reserves in recent months, real yields have
moved higher since the beginning of the year, while inflation
expectations have declined.
China and emerging markets led the build-up in global foreign
exchange reserves following the 1997 Asian crisis to a peak of $12
trillion last year. This cash pile shielded them from the 2007-08
crisis, and it looks as if it is once again being deployed.
It's not clear whether China has sold U.S. Treasuries over the last
month, or if so, how much. Bank of America Merrill Lynch speculated
in a research note that if China sold between $7 billion to $10
billion a day of U.S. Treasuries in the three weeks since the
Chinese yuan devaluation on Aug. 11, it might have dumped as much as
$150 billion in U.S. government bonds.
These are large numbers given the fact that the total net issuance
of Treasuries this year will only be about $500 billion, said Bank
of America Merrill Lynch in its research note. As of June 2015,
China held $1.27 trillion in U.S. Treasury securities, according to
capital flows data from the U.S. Treasury Department.
"The presence of central banks within our markets is over-riding and
it's all-encompassing and has driven the activity since 2008," said
PineBridge's Vanden Assem.
(Reporting by Gertrude Chavez-Dreyfuss; Additional reporting by
Michael Connor, Richard Leong, and David Randall; Editing by David
Gaffen and John Pickering)
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