The chaos in the U.K. sovereign-bond market has impacted global markets in a number of ways, but in the U.S. it caused Treasury bond yields to initially rise in sympathy, while increasing the cost at which the U.S. Treasury financed nearly $90 billion in debt.
On Monday, an auction of $43 billion in 2-year Treasury notes saw a “tail” of 1.6 basis points — meaning the newly issued bonds were purchased at a markedly lower price than bonds of similar duration trading in the secondary market.
Bidding by pension funds, central banks and other investors was notably tepid, leaving Treasury dealers to take home more than 22% of the issuance, compared with an average of 18.6% over the past six auctions, according to an analysis from BMO Capital Markets.
And the weakness didn’t end with the 2-year auction. One day later, demand during an auction of $44 billion in five-year Treasury notes was even weaker, as the bonds were ultimately sold with a “tail” of 2.6 basis points, as dealers once again were left to pick up the slack.
With the Federal Reserve accelerating the pace at which Treasury bonds are rolling off its balance sheet, investors have been keeping an eye out for signs of deteriorating liquidity in the bond market. But rather than blaming the Fed, or elevated levels of policy uncertainty in the U.S., market ructions emanating from Europe were seen as the culprit.
U.K. gilt yields have soared since last Friday and the pound fell to a record low against the U.S. dollar as investors dumped government bonds in response to what they deemed a dangerously profligate budget by new Chancellor Kwasi Kwarteng. Kwarteng’s proposal for £45 billion of debt-funded tax cuts at a time when inflation was running at a near 40-year high of 9.9% and was lambasted by the International Monetary Fund.
When asked about the poor auction results, several bond-market strategists told MarketWatch that the instability in the U.K. markets was largely to blame.
“The chaotic movements in U.K. interest rates are plowing through the border,” said Guy LeBas, chief fixed income strategist and portfolio manager at Janney.
Extreme volatility leads to ‘value-at-risk’ shock
As LeBas and others explained, extreme volatility can force investors to back away from the market because of the impact on their risk-management models.
On Tuesday, gilt yields fluctuated in a range of more than 100 basis points, LeBas said, as bond prices plunged.
The volatility was so intense that the Bank of England unveiled plans early Wednesday to intervene by buying bonds at “whatever scale is necessary.”
News of the BoE’s intervention was felt across global markets. U.S. Treasury yields fell and U.S. stocks traded higher after the news, with stocks eventually opening in the green as U.S. Treasury yields tumbled in sympathy with Europe.
But these wild moves in what are normally relatively stable assets can have a lasting impact by creating something called a “value-at-risk” shock. This in turn causes investors and sell-side firms to rein in leverage and adjust their positions to be more defensive until the market ructions have passed. In the interim, it can help to exacerbate the volatility.
Treasurys have been volatile since the start of the month — even more volatile than stocks by some measures — and rising bond yields have helped contribute to the chaos in equities.
What does this mean for bonds?
As a result, the Bloomberg Aggregate U.S. Bond Index, which is tracked by the SPDR Bloomberg U.S. Aggregate Bond UCITS ETF
is on track for one of its worst monthly performances in history.
To be sure, the chaos in the U.K. isn’t the only factor dampening demand for Treasurys at auction. Bond-market experts also blamed the immense “policy uncertainty” in the U.S.
“Recent weakness in Treasury auctions is largely a function of enormous market volatility and uncertainty about where rates go next,” said Gennadiy Goldberg, a senior U.S. rates strategist with TD Securities.
“While auction yields are certainly attractive to investors at multi-year highs, expectations for further Fed rate increases and volatility in U.K. and European rates has led to a significant degree of caution.”
Despite the weakening demand, LeBas pointed out that the auctions were still heavily oversubscribed, with investors submitting bids for more than twice the nominal amount of bonds that were ultimately sold.
“There’s no worry about a failed auction,” LeBas said. Although he did acknowledge that the market chaos has led to a modest increase in the cost at which the U.S. federal government can finance its debt.
Still, Peter Boockvar, chief investment officer at the Bleakley Advisory Group, pointed out that it’s somewhat surprising that auctions aren’t seeing more demand from investors, considering that Treasury yields had touched their highest level in more than a decade.
“Bottom line, what’s amazing and concerning at the same time is that the 5 [year] yield is at the highest level in 15 [years] and up from 1.21% at the beginning of 2022, this is not bringing out more demand,” Boockvar said.
In the wake of the Bank of England’s intervention in the U.K. gilt market early Wednesday, Treasury yields tumbled as global bond markets rebounded, with the 10-year yield falling 16.5 basis points after
briefly topping 4% earlier on Wednesday for the first time in more than a decade.
However, the rise in the 10-year U.S. Treasury yield above 4% early Wednesday before the BOE intervention on could spur more volatility in U.S. stocks, market analysts said.
Meanwhile, the 2-year Treasury yield
fell 18 basis points to 4.131%.