U.S. Government Bonds Rally After Biggest One-Day Selloff in 2016 Moves come after Fed’s meeting minutes signaled a June rate increase was possible
wsj.com
By
MIN ZENG

May 19, 2016 10:45 a.m. ET

U.S. government bonds gained ground Thursday following their biggest one-day selloff in 2016 as anxiety over a near-term interest rate increase by the Federal Reserve continues to grip financial markets.

Investors shed bondholdings on Wednesday after the minutes from the Fed’s April meeting signaled that a rate increase in June isn’t off the table. Higher interest rates tend to dilute the value of outstanding government bonds.

Yet growing angst over the Fed is generating crosscurrents in the global markets Thursday. The possibility that the Fed could raise rates again after its December increase boosted the appeal of the dollar, which in turn rattled the commodities markets. Prices of crude oil, gold, silver, copper and some other commodities were all posting big declines Thursday.

ENLARGE
The Federal Reserve building at sunrise in Washington, D.C. PHOTO: BLOOMBERG NEWS

Lower commodities prices aren't only a sign of investors dialing back risk appetites, they also reduce the threat of inflation. Both cases enhance the appeal of U.S. government bonds, especially long-term debt.

”I think the biggest issue is investors that have had cash accumulating on the sidelines have been waiting for an opportunity to deploy cash at higher yield levels and they are doing so now,’’ said Larry Milstein, head of government and agency trading at R.W. Pressprich & Co. in New York. “If the dollar continues to strengthen, lower commodity prices will help keep a lid on bond yields.’’

In recent trading, the yield on the benchmark 10-year Treasury note was 1.840%, according to Tradeweb, compared with 1.882% on Wednesday.

Even short-term Treasurys, whose yields are highly sensitive to the Fed’s policy outlook, regained some poise. The two-year note’s yield was recently at 0.884%, compared with its two-month high of 0.902% Wednesday.

Yields fall as bond prices rise.

Thursday’s global market moves reflect how sensitive investors are to the Fed’s interest rate outlook. After the Fed raised rates in December for the first time since 2006, riskier global markets from stocks to oil sank between the start of January and mid-February.

Analysts say market volatility is going to rise leading into the Fed’s June 14-15 policy meeting.

Markets are vulnerable to sharp pullback given crowded positioning. In particular, bullish wagers on gold and oil have soared in recent months, while negative bets had grown on the dollar. That means if the dollar’s strength picks up more speed, it would put more selling pressure on commodities.

In the minutes, Fed officials said an interest-rate increase in June was possible if incoming data showed an improving economy. While officials weren’t committed to moving in June, they clearly sought to keep their options open at that meeting and in the communications that they planned to release afterward.

Interest-rate futures—a popular tool for hedge funds and money managers to place bets on the Fed’s future policy moves—showed Thursday that the odds of an interest-rate increase at the Fed’s policy meeting next month were 26%, according to CME Group. The odds pulled back from 34% Wednesday, but were higher than a month ago when the probability was zero.

The developments in the financial markets should be welcomed by Fed officials as they have been struggling to guide market expectations over the timing of the Fed’s rate increases. The adjustments in the markets move the markets closer to the Fed’s tightening plan. In its March meeting, Fed officials projected two rate increases this year.

But the renewed strength in the dollar could complicate the Fed’s plan as it would tighten financial conditions and likely sap investors’ appetite for stocks, say analysts.

The Fed’s cautious stance in raising rates has crimped demand for the dollar, which has softened this year. But this month, the dollar has regained some ground. Meanwhile, the Chinese yuan has been weakening lately after gaining ground earlier this year. A large yuan devaluation by China’s central bank last August had sent shock waves globally.

Many money managers and bond traders say what matters more to the Fed’s policy outlook is views from Fed Chairwoman Janet Yellen.Ms. Yellen has signaled in recent months that she would be cautious in raising interest rates amid an uncertain global growth outlook.

The Fed chief will speak at Harvard University on May 27 and on June 6 before the World Affairs Council of Philadelphia. The June speech will come three days after the May jobs report, and just over a week before the Fed’s June policy meeting.

Michael Lorizio, senior trader at Manulife Asset Management, which had $325 billion at the end of March, said this makes her appearance early next month “a powerful calendar event’’ for markets. The platform will offer Ms. Yellen an opportunity if she wants to prepare markets for a near-term interest rate increases, he said.