The decline in U.S. Treasury yields on Wednesday is proving a real head scratcher for fixed-income investors and broader financial markets.

Earlier in the session, the 10-year Treasury note
TMUBMUSD02Y,
0.224%

deepened its slide to the lowest level since February, touching an intraday nadir Wednesday morning at 1.285%, FactSet data show.

The yield decline in the benchmark debt, used to price everything from mortgages to corporate debt, has flummoxed investors because it comes at a time when worries about surging inflation are elevated.

Steadily rising prices are bad for long-dated debt because it can chip away at Treasury’s fixed value. So, instead of being bought, long-dated bonds should be sold and yields should increase commensurately.

Most analysts had forecast 10 year Treasury yields to hit around 2% by this point in the recovery from the COVID-19 pandemic.

FactSet data

However, that hasn’t happened, which is leading some on Wall Street to try to discern what the Treasury bond moves, including a flattening in the yield curve, or difference between yields on short-dated notes and longer-dated bonds, means for the economic outlook.

Check out: What to expect if ‘peak everything’ already has happened and markets feel the force of gravity again

The pain trade

Bets that yields will head higher have been a losing wager on Wall Street and the unwinding of some positioning has contributed to aspects of the fall in long-dated yields.

Most traders are positioned for 10 year yields at or around 2% in the near term because it is a bet that makes sense given that some Federal Reserve policymakers have articulated plans to eventually scale back on monthly purchases of assets that include some $80 billion in Treasurys.

Periodic surges in yields have forced a number of unwinds of short Treasury bets, which have amplified recent moves, analysts have said.

“And right now with rates, the pain trade is a continued move lower and flatter,” Greg Faranello, head of U.S. rates at AmeriVet Securities, wrote in a Wednesday note.

Weaker economy

A dimming outlook foraa fast economic recovery, highlighted by an uneven rebound in the labor market, may also be contributing to traditional haven buying for Treasurys.

U.S. businesses are struggling to fill millions of available jobs. Although the U.S. created 850,000 new jobs in June, it would take more than a year at that rate to restore employment to pre-pandemic trends, a far slower rebound than anticipated by economists months ago.

On Wednesday, the number of available jobs set a record for three straight months, with May producing a record 9.21 million openings.

To be sure, many are expecting that the jobs market will normalize as fiscal stimulus measures to help out-of-work Americans roll off in the months to come, compelling a fuller return to work.

Mizuho economist Steven Ricchiuto, in a Wednesday research note, wrote that there are some signs in layoffs and quits that imply that only a temporary challenge by businesses looking to fill jobs.

“Layoffs have declined to a new all-time low, and the level of hiring and quits have declined and are now closer to their pre-pandemic levels,” the Mizuho economist wrote. He continued:

‘This is somewhat concerning as it suggests recent net payroll gains are unsustainable. All together, these dynamics do offer some support for the argument put forward by the Fed hawks that the structural rate of unemployment has increased. However, policy changes that are driving these shifts will be largely rolled back over the coming months, so in our view, at minimum, it is highly premature to conclude that the labor market has structurally shifted.’
Treasury appetite

Demand for U.S. government debt has been strong, particularly as investments outside the U.S. offer yields at or below 0%. The German bond yield
TMBMKDE-30Y,
0.185%

hit its lowest level since March. That appetite for European debt has had some spillover to the U.S., investors say.

“The moves seemed to be more of a result of trades being stopped out rather than anything more fundamental,” wrote analysts at Mizuho in a report cited by Reuters.

“There is still a lot of cash to be put to work, and the possibility of momentum funds closing shorts ahead…may sustain the strength in rates in the near-term,” Mizuho said.

Delta, delta, delta

Concerns about the fast-moving delta variant of the coronavirus that results in COVID-19 also has been blamed for some buying in Treasurys.

The delta variant is now the most dominant form of SARS-CoV-2 in the U.S., according to new data from the Centers for Disease Control and Prevention. The more transmissible version of the coronavirus has raised concern that it may cause more infections among the unvaccinated, and even the vaccinated may have less protection against the delta variant than other variants of concern.

A dearth of supply

A lack of supply of Treasury bonds may also be an issue, which might sound odd, given the huge fiscal deficits the federal government has run up in its efforts to buffer the economy against the COVID-inspired downshift.

However, the Treasury General Account, or TGA, which the U.S. government uses to run most of its day-to-day business and is managed by the New York Fed, is now being steadily wound down after being run up to help mitigate the economic pain of the pandemic.

That reduction in the TGA has had the effect of shrinking the supply of bonds, one key factor in the recent moves in yields, argues John Luke Tyner, fixed-income analyst at Aptus Capital Advisors, which manages some $3 billion.

“We’ve just had less issuance because the government can rely on TGA to finance expenses,” Tyner said.

The Fed

The Federal Reserve statement and Fed chair Powell’s press conference after fits June 15-16 gathering highlighted the strange spot fixed-income investors find themselves in. The rate-setting Federal Open Market Committee broached the topic of tapering its $120 billion a month purchases of Treasurys and mortgage-backed bonds, and also the eventual raising of policy interest rates, which stand at a range between 0% and 0.25%.

A Fed on a more hawkish footing, one that suggests that the institution will be more inclined to remove monetary accommodation as the economy recovers, should be nudging yields up.

Investors will be eager to glean clues to future policy from the minutes of the Fed’s June meeting when they are published Wednesday afternoon.

2% or bust?

Despite the yield slump, a number of analysts are still committed to the view that the 10-year Treasury will hit 2% by the end of 2021, which would, perhaps, mark a spectacular surge in the last half of a year.

“We anticipate that the 10-year U.S. Treasury yield will finish the year at 2.0%,” writes Lauren Goodwin, economist and portfolio strategist at New York Life Investments, in a recent research report.

She makes the case that the sluggish pace of recovery in jobs is temporary, while rising debt and other factors won’t lead to a persistent shift in inflation.

“My estimation of these structural factors suggests that the underlying inflation trend will firm only modestly as the recovery continues…For now, any determination that they will be inflationary beyond the next 2-3 years’ recovery period remains somewhat speculative,” she wrote.

Aptus Capital’s Tyner says that if the 10-year breaks below 1.20% in its decline, then that could signal more structural problems in the economy, as gauged by fixed-income investors.

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