Market Insider

What's causing the fire sale in the bond market

Trader sees bond rout continuing
Trader sees bond rout continuing

There's a fire sale in the bond market, and the November jobs report could make it burn even hotter.

The wild move came amid speculation that Friday's employment report could be better-than-expected and drive interest rates even higher.

Interest rates surged Thursday, with the 10-year yield spiking as much as 12 basis points — or 0.12 percentage points — at its peak, to 2.49 percent, the highest yield since June 2015. Yields move inversely to prices and rates snapped higher across the whole yield curve. The pressed up against 1.17 percent and the 30-year rose to as high as 3.15 percent.

In afternoon trading, some of the selling subsided, and the 10-year yield slipped back to just under 2.44 percent, but 2.50 is being watched as the next psychological line in the sand.

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"In order to stay above 2.50, it's got to be a really good number. The way we're going, it's like an unhinged market. It's also going to be counterproductive for things down the road. This is not a healthy adjustment in rates. There's going to be some losses on this," said George Goncalves, head of rate strategy at Nomura.

The 10-year yield affects consumer loans especially home mortgage rates, which have already risen near 4 percent, slowing borrowing activity. The 2-year is the rate most closely watched as a signal about the market's expectation for Fed rate activity. The Fed is expected to hike rates Dec. 14 but traders have been speculating a stronger economy could force it into a faster hiking cycle next year.

Strategists say Thursday's rate spike was driven by a combination of factors and at the same time inexplicable in its scope. The overriding themes are that the world is moving to a higher interest rate environment and for the first time in years, there could be inflation. OPEC's deal to cut production Wednesday, drove oil prices 15 percent higher in just two days, ramping up inflation expectations that already had been on the rise.

President-elect Donald Trump's plans to add stimulus to the economy and cut tax rates for corporations and individuals has added to expectations that an already warming economy could expand even more, and bring higher rates and inflation with it. U.S. data has also been better than expected, with ISM data Thursday showing that manufacturing activity expanded in November more quickly than in any month since last year.

Big jobs number coming Friday?

The stronger readings in this week's ADP private sector payrolls of 216,000 jobs has also sparked expectations that Friday's government employment report could be better than expected, and also show a bigger-than-expected jump in wages. Economists expect 175,000 jobs were created in November, and average hourly earnings rose 0.2 percent. The unemployment rate is expected to hold at 4.9 percent.

Goldman Sachs economists Thursday afternoon bumped up their expectations for the jobs report to 200,000 nonfarm payrolls, following the ADP report.

"There's a new psychology in the market. We've spent so long looking to buy rates, we've switched around," said Aaron Kohli, interest rate strategist at financial group BMO.

The market is watching for a break to 2.50 percent on the 10-year, but strategists say there are not many strong support levels between there and 3 percent. One point strategists are watching is 2.60 percent, as well as 2.75 and 2.80 percent.

"The reality is I'm not sure that tomorrow's (jobs report) can provide enough of a boost to get there," said Kohli of the 2.60 level. "We always tend to focus on the headlines. What's more important this time around is the hourly earnings. You could be adding stimulus into a market where labor conditions have already tightened and wages are moving up."

You want yields to be higher because there's expectations for growth ... but you don't want them selling off, or you don't want them up 60 basis points because somebody got squeezed. You want them up on future growth.
Aaron Kohli
interest rate strategist, BMO

Goncalves said the market is moving too fast. "I really think we're getting ahead of ourselves, and people are nervously anticipating tomorrow. I think that matters more than the fundamentals. I think it's more a supply-demand imbalance. I really don't believe that it's just that we have new data to digest and rates have to go higher. It's really more a buyers' strike, and if you're going to come into the market, you're going to want to be compensated for it. We've broken above 2.40 and nobody wants to step up," he said.

Other factors that affected market psyche were concerns about the European Central Bank ending its quantitative easing program. Reuters reported from unnamed source that the ECB will extend its bond purchases beyond March and decide whether to formally signal after its meeting next Thursday that it will eventually end the program. That sparked more selling in German bunds, and that activity pressured Treasurys in late morning trading. The market is also watching Sunday's Italian constitutuional referendum, which is expected to fail and result in a change of government.

The Treasury market was also seeing hedging interest due to corporate bond issuance. There was a pickup in issuance Thursday, after low activity Wednesday.

Companies issued $13.8 billion in investment grade debt Thursday, according Informa Global Markets. Three big banks — Citigroup, JPMorgan and Wells Fargo — were among the issuers.

Strategists said the fact that banks are moving to borrow in a rising rate environment does reinforce the view that managements see rates rising. Reich said corporate investment grade issuance could surpass last year's total of $1.25 trillion Thursday.

The bond market also continued to chatter about the fact that Steven Mnuchin, Trump's pick for Treasury secretary, said on CNBC Wednesday that the Treasury could consider longer duration bonds as an option.

Kohli said the action is welcome. "We've been waiting for a fire," he said, noting its helpful the economy is firming. "You want yields to be higher because there's expectations for growth ... but you don't want them selling off, or you don't want them up 60 basis points because somebody got squeezed. You want them up on future growth," he said.

Kohli said the month end trading in November was very telling and marked a turning point. Institutions who trade against a benchmark weren't jumping in to add to their holdings, as they have typically done at month end during the many years of low rates. "In the past they would have had to go out and buy to match the benchmark. It's dropped off … in the past it made sense to do that because the prevailing direction of rates was lower," he said.

"I think any time you violates these bounds usually you get a pullback in yield so you might retrace a bit. We've gotten here so quickly. We got from (10-year yield) 1.70 to 2.50 in very short order. It's been a big shock to the market. I think the immediate knee jerk reaction will be for shorts to take profits," said Kohli.