That is because the purchase of government bonds by both the US Federal Reserve and the Bank of England is not helping sustain lower yields.
And it raises the prospect that the central banks will have to increase their fire power.
The Fed has bought more than $30bn of its planned $300bn purchases of Treasury debt since the programme began late last month. In that time, after a sharp initial drop, yields have moved higher, as hefty new supply from the US Treasury continues flowing.
“The Fed’s problem is that the market realises that $300bn in Treasury buy-backs is just a drop in the bucket compared to $2,500bn in net Treasury issuance this fiscal year,” says William O’Donnell, strategist at UBS. “It’s a $300bn thumb in a dyke springing leaks everywhere.”
After falling to 2.5 per cent from 3 per cent when the Fed confirmed it would start buying Treasuries, the yield on the 10 year note is currently back around 2.9 per cent. This week’s selling of stocks has helped lower yields, but the move has been muted for now.
If 10-year US yields rise above 3 per cent, it may negate some of the recent decline in 30-year fixed mortgage rates, which are at historic lows for US home owners.
In the UK, the effectiveness of quantitative easing is also in doubt, after a euphoric start to the programme that saw benchmark yields plunge.
Yields on 10-year UK bonds have risen by about 50 basis points from a low of 2.91 per cent after the Bank of England announced plans to buy up to £75bn ($110bn) of gilts on March 5.
The increase in yields is partly due to signs of risk appetite returning to the markets, which takes away a natural support for gilts and Treasuries. The recent rebound in equity markets, amid hopes of green shoots appearing in the economy, has also put pressure on government bond prices on both sides of the Atlantic.
The rise in Treasury yields has been accompanied by rising inflation expectations as investors worry that the Fed’s outright purchases of Treasuries and mortgages under quantitative easing will ultimately spark inflation.
The expected average inflation rate for the next 10 years recently touched a six-month peak of 1.5 per cent, up from 1.1 per cent last month. Such an inflation expectation, however, is very low and dealers say supply is the main issue for the Treasury market.
The Fed’s planned purchases in Treasury debt this year is a fraction of the overall $6,000bn in outstanding debt and expected hefty supply due in the coming months and years.
Over the next month, at least $200bn in net new issuance is forecast. It means that while the Fed comes in and buys an average of $12bn a week, the US Treasury will pump more supply into the market, pushing yields higher.
For dealers, competition between the Fed and the Treasury creates a favourable trading environment at a time when dealer ranks have been thinned and bid-offer spreads are wider than normal, enhancing profits.
Trading opportunities have also flourished in gilts as dealers report that most sellers to the Bank of England have been hedge funds or bank proprietary desks. Many of these groups have sold bonds at high prices to the Bank of England and then bought them back at lower prices to book quick profits, which has no impact on the economy.
That is preventing the Bank of England from driving yields on 10-year gilts down to 2.5 per cent, a level where so-called real money accounts, such as life insurance companies, are likely to sell. It is hoped that these funds will then buy sterling corporate bonds, lowering the funding costs for UK companies and helping to stimulate the wider economy.
The rise in UK gilt yields comes amid worries that the Bank of England is not as committed to quantitative easing as dealers first thought following comments by Mervyn King, the Bank’s governor, to a parliamentary committee that the programme could be eased should signs of inflation emerge. The Bank may make further comments on quantitative easing after its rate setting meeting today.
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