By Gertrude Chavez-Dreyfuss, Suzanne McGee and Laura Matthews
NEW YORK, October 9 (Reuters) – It’s crisis time on the bond market.
U.S. Treasury yields have risen sharply since the start of the war with Iran in February, with the 10-year yield up some 135 basis points to 5.23% and the 30-year yield up about 110 basis points from its March low of 5.614%. Both are trading at levels not seen more than two decades ago.
Investors are watching to see if the bond sell-off begins to create its own momentum. Some key technical metrics suggest a new push toward even higher yields may be ahead, creating a feedback loop that amplifies market stress, although there is also reason to believe buyers will step in soon, seeking to keep yields at their most investor-friendly levels since George W. Bush was president.
“People in the market are recalibrating their expectations,” said Dustin Reid, fixed income strategist at Mackenzie Investments.
Here are four signs that sales could be getting worse.
VOLATILITY INCREASES IN RATE OPTIONS
Investors seek protection against rising yields, called “payer bias,” in the options market. Investors use these markets to insure their portfolios against large swings in yields without having to sell their Treasury holdings.
Demand for short-term protection against a rise in U.S. 10-year swap rates has intensified, pushing the cost of insurance against a 200 basis point rate rise over the next three months to 132 basis points on Monday, the highest since the March 2023 banking crisis triggered by the collapse of Silicon Valley Bank.
Swap rates refer to the cost investors pay to lock in a fixed interest rate instead of paying a variable rate.
Even though options are tied to swap rates rather than Treasury yields, the two typically move in lockstep, making rising payer bias an indication of concern about the risk of higher long-term Treasury yields.
Implied volatility, a key component of options prices, jumped to 21.4 basis points for one-month options on 10-year swap rates, the highest since late March, reflecting growing uncertainty over the path of long-term yields.
AI DEVELOPMENT REFORMS CREDIT MARKETS
According to investors, the increase in corporate issuance intended to support the development of AI has largely contributed to this wave of sales. Spreads have remained tight, but buyers of long-term bonds issued by AI hyperscalers use the Treasury market to hedge their duration risk, a measure of their exposure to rising interest rates — a practice that has recently spurred selling.
“When a trade happens at noon, in the afternoon everyone is selling Treasury futures,” said Neil Sun, a portfolio manager at RBC BlueBay Asset Management, which focuses on investment-grade credit. Those who don’t hedge sometimes sell Treasuries outright to make way for higher-yielding investment-grade bonds.
Goldman Sachs predicts that hyperscalers could sell a record $420 billion of debt next year, which likely means more hedging or selling of government securities.
MORTGAGE COVERAGE IS INCREASING
Investors exposed to mortgage assets also hedge against the liquidation of Treasury bonds. As rates rise, the expected life of mortgage-backed securities lengthens, making them more sensitive to further changes in yields in what is known as duration risk.
Investors often respond by increasing interest rate hedges to compensate for this additional duration risk, a process known as convexity hedging. This includes selling Treasury futures, which can increase selling pressure in bond markets.
“The market is home to a significant cohort of mortgages issued over the past three years at coupons relatively close to current mortgage rates,” said Mike Riddle, chief executive of Eris Innovations, a Chicago-based developer of futures and options products. He said that could mean more hedging, adding that nine large deals this month show mortgage investors are scrambling to protect their positions.
STRENGTHENING THE YIELDS CURVE
The further steepening of the 10-year and 30-year yield curves is another warning, suggesting that investors are demanding a higher premium to hold longer-term government debt. The 10-30 year spread widened to about 37 basis points this week, as the 30-year yield rose faster than the 10-year yield.
Although the curve has been steeper before, including in late July when that gap reached 52 basis points, the latest move comes when these yields are already near multi-decade highs. This suggests that the move increasingly reflects a growing term premium, rather than a broad reassessment of Fed policy. A higher term premium suggests that investors demand higher compensation for holding long-term debt.
“There’s just more interest in the 10s than the 30s from investors, who see that there’s a lot more risk of things going wrong in the fiscal situation” in the United States over a longer period, said Alex Morris, co-founder of fixed-income asset management firm F/m Investments. “Essentially, people are saying to Treasury, ‘I don’t know if you’ve got this under control.'”
(Reporting by Gertrude Chavez-Dreyfuss and Laura Matthews in New York and Suzanne McGee in Providence; editing by Colin Barr and David Gaffen)
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