ANALYSIS-Latest bond market rout unhinges U.S. short-term yields
NEW YORK, Sept 5 (Reuters) - The punishing sell off in the U.S. Treasury market has taken a surprising turn, with yields on shorter maturities getting swept higher at a startling pace. The rise defies a widely held view that they would remain anchored at historic lows by the Federal Reserve's pledge to keep a lid on short-term rates.
In what some see as investors second-guessing the Fed's resolve, the 2-year Treasury note yield on Thursday jumped above 0.50 percent for the first time since June 2011.
It has risen 0.20 of a percentage point in a little more than three weeks, and is now roughly double its average level over the past year of around 0.27 percent.
The move could have broad implications for consumers and businesses. On the upside, interest rates on everything from savings accounts to money market funds that have been negligible for nearly five years could finally start to rise. At the same time, borrowing costs for short-term loans, including those between banks, would increase, potentially pinching corporate profit margins.
"The market is beginning to believe that if the Fed starts to taper (its bond purchases) in 2013 that they will likely begin to raise the Fed Funds rate by the end of the 2014," said Tom Sowanick, co-president and chief investment officer with OmniVest Group LLC in Princeton, New Jersey.
Until this week, the so-called front end of the Treasury yield curve, where 2-year notes reside, was thought to be a relatively safe harbor in the stormy sea the bond market has become since Federal Reserve officials began talking up plans to cut back on their massive stimulus.
The central bank has each month been buying $85 billion of Treasuries and mortgage-backed securities, a program known as quantitative easing, or QE, and is expected to start curtailing the purchases as soon as its next meeting on Sept. 17-18.
That's because 2-year notes are seen as effectively a market proxy for the Fed's official policy rate, the Federal Funds Target Rate, which has been pegged at between zero and 0.25 percent since the height of the financial crisis in late 2008.
Even while signaling a desire to wind down QE, the Fed has pledged to maintain this zero-interest-rate policy until the U.S. unemployment rate, currently at 7.4 percent, drops to 6.5 percent, as long as inflation remains in check. Fed policymakers' most recent forecasts suggest the target rate will stay put through at least the middle of 2015.
That had fueled the view that 2-year yields would remain tethered in place even as the wider bond market got roiled this summer by the "will-they-or-won't-they" debate over when QE will be wound down.
Further out on the yield curve, benchmark 10-year yields pierced 3 percent on Thursday for the first time since July 2011.
SUMMERS SEEN AS A POTENTIAL HAWK
So what changed?
A wave of encouraging economic news at home and abroad in recent days has strengthened the perception the U.S. economy is on a solid enough footing to start the QE wind down.
There has also been the emergence this summer of former U.S. Treasury Secretary Larry Summers as the candidate perceived by the market to be President Barack Obama's choice to succeed Fed Chairman Ben Bernanke, whose term ends early next year.
Summers is seen as skeptical of the effectiveness of QE in boosting the economy, thus more likely to wind it down quickly. He is also seen as more likely to raise rates quickly if inflation pressures start to mount, throwing the current Fed regime's zero-interest-rate policy into some doubt.
By contrast, his top competition for the post, current Fed Vice Chairwoman Janet Yellen, is a known supporter of the QE program authored by Bernanke. She is an advocate of using monetary policy to stimulate jobs growth, so is seen as paring stimulus slowly and refraining from raising rates quickly if she gets the job.
"If Summers replaces Bernanke, the market will anticipate a quicker end to QE and the quicker start of rising fed funds," Sowanick said.
Another factor is that the Fed does appear to be gearing up for managing rates when the zero-interest-rate era ends.
Minutes from the latest Fed meeting in July showed policy-makers were briefed on a new tool being developed to help drain cash from the financial system to help achieve and maintain a future target rate. Some analysts viewed this as a hint the Fed is thinking more intently about reducing stimulus.
"Their money and their mouths are shifting toward the tightening side," said Larry Dyer, chief U.S. interest rate strategist with HSBC Securities USA in New York.
Rate futures markets have reflected this shift.
Short-term interest rates futures imply that traders see a 43 percent chance the Fed will raise short-term rate at its July 2014 policy meeting, up from 20.7 percent a month ago.
Their view of a likelihood of a Fed hike by the end of 2014 goes up to 78 percent, against 41.6 percent a month ago.
But bond bulls continue to hold out some hope even while the overall U.S. bond market may be on pace for its worst performance in at least 40 years. The swift rise in bond yields has already led to a surge in interest rates on everything from mortgages to corporate loans, and this might have already slowed the U.S. economy.
Evidence of this drag, in the housing market in particular, might cause the Fed to forestall dialing down QE, which could revive the appetite for all Treasuries.
HSBC's Dyer, for one, takes that view. "I see yields going lower because the economy can't sustain these higher rates," he said.
(Additional reporting by Jennifer Ablan; Editing by Dan Burns, Martin Howell)