The 1-year Treasury bond yield is testing 4%, a level traders say could spill over to other interest rates and send shivers through financial markets as the Federal Reserve continues its campaign to shrink its $8.8 trillion balance sheet. Dollar seriously pushes .
This balance sheet process, known as “quantitative tightening,” is expected to complement a series of aggressive central bank rate hikes, one of which is expected to arrive next Wednesday. According to BofA Securities rates strategist Mark Cabana, the Fed is “now tightening on all cylinders” as the “training wheels” fall after a slow start from QT. And traders say it’s one of the reasons for Thursday’s moves in the one-year yield, which included touching or exceeding 4% at times before pulling back.
“Four percent is a magic number and one that scares many investment markets, including stock markets, and basically everyone,” said chief trader John Farawell of Roosevelt & Cross, a bond issuer in New York. The Fed’s QT process is one reason for this and is “putting pressure on the front end of the curve.”
A 4% yield is likely to spill over to other rates in the Treasury market as expectations surrounding aggressive Fed rate moves solidify, Farawell said by phone on Thursday. “You might see more of what you’re seeing now — more stress in the stock market — and you might see stock investors exiting.”
Read: Stock market wildcard: What investors need to know as the Fed shrinks the balance sheet faster
In fact, all three major US indices are DJIA,
closed lower on Thursday as government bond yields continued to rise.
Data provided by Tradeweb shows that the one-year rate TMUBMUSD01Y,
rose slightly above 4% three times in the morning and afternoon in New York before retreating.
According to FactSet, the one-year yield, which reflects expectations for near-term Fed policy stance, has not ended the New York trading session above 4% since Oct. 31, 2007.
Meanwhile, the bond market flashed more worrying signals about the outlook: the spread between the 2-year and 10-year Treasury rates fell to -41.3 basis points, while the spread between the 5-year and 30-year rates fell to -19.3 basis points shrank.
Financial market participants have slowly shifted to the view that the Federal Reserve will continue to tighten funding conditions until something collapses in the US economy to end the hottest inflationary spell in four decades.
Aside from QT, other reasons for the move in the one-year yield towards 4% include traders’ increasing focus on the level at which policymakers will end rate hikes, known as the tail rate, and concerns over the likelihood of one of the next moves in the Fed could be a gargantuan 100 basis point hike, according to one strategist.
Higher interest rates, particularly for one-year government bonds, benefit investors who have not yet had a chance to enter the bond market, giving them the opportunity to earn higher yields at a lower price. “We could see investors moving into the safety of Treasuries and maybe we’ll see more players coming into the bond market. Treasuries could become a viable option for some people,” Roosevelt & Cross’s Farawell told MarketWatch. He noted that between 2020 and earlier this year, the interest rate on one-year government bonds was “fractionally” or almost zero.
When policymakers flooded the markets with liquidity through the process known as quantitative easing in the era of easy money, stocks were seen as one of the biggest beneficiaries. So it’s only logical that the opposite process – quantitative tightening – and its acceleration could continue to hit stocks.
This month, the Fed’s maximum pace of deleveraging rose to $95 billion a month in Treasuries and mortgage-backed securities, up from $47.5 billion a month earlier. This increasing QT pace will bring more Treasuries and mortgage-backed securities into private hands, create aggressive competition among commercial banks for funding, and lead to higher borrowing costs, according to BofA’s Cabana.
The effects of QT so far have been “minimal,” Cabana wrote in a note Thursday. Over time, however, this should ultimately lead to “higher funding rates, tighter funding conditions and headwinds for risky assets.”
See: The next financial crisis may already be looming – but not where investors would expect it to be
Still, there was a feeling among traders that the Fed’s accelerated QT pace is already having an impact.
“Reaching 4% on 1-year returns has a psychological impact – which has the potential to spill over into other capital markets overseas,” said Larry Milstein, senior managing director of government debt trading at RW Pressprich & Co. in New York. “People are realizing now that the Fed has to stay higher for a long time, inflation isn’t coming down as fast as expected, and the final rate is going up.”
“TINA has been talked about for a long time, but you don’t necessarily have to be in the stock market to make 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 pulling money out of stocks and investing it in shorter-dated government bonds.