The Treasury Market Has a Big Chicken-and-Egg Problem

(Bloomberg Opinion) -- The world's biggest bond market faces a conundrum. Figuring out the answer could guide traders for the rest of the year and into 2019.

The market for principal- and interest-only U.S. Treasury securities, known as Strips, rose by a record $12.2 billion in October, according to data released Tuesday. These zero-coupon bonds are favorites of defined-benefit pension funds and other asset-liability managers because their long duration characteristics align with their obligations. Indeed, almost all the stripping was done on debt due in roughly 30 years.

Here's the thing: Thirty-year Treasury yields rose about 19 basis points last month, eventually touching a four-year high on Nov. 2. Such unprecedented demand for Strips would normally indicate support at the long end of the market. It raises the specter of an even more severe sell-off — and a drastically steeper yield curve — if that activity slows down.

But it could also be that the higher bond yields drove that demand. After all, the most extreme move came early in the month, on Oct. 3, when the 30-year yield rose by 12 basis points. Given that the long bond fluctuated in the ensuing three weeks, it's conceivable that the Strips buyers emerged and kept yields relatively in check. But just from looking at the numbers, it's hard to know for sure.

Interpreting this chain of events will be crucial for bond traders in the months ahead. For one, it dispels the idea that pension demand for fixed income would evaporate after the Sept. 15 deadline for companies to receive favorable tax treatment for their contributions to retirement funds. I wrote ahead of that date that I didn't see the cutoff as a day of reckoning for the flattening yield curve.

It might be time to rethink that premise, though. For those who thought that the U.S. yield curve would continue to flatten toward inversion, the October data has to be a bit unnerving. Sure, investors appear to have poured in when long-term yields rose, but it wasn't enough to outweigh the selling pressure and stop the curve from reaching the steepest levels in months. What happens if that doesn't happen next time?

My Bloomberg Opinion colleague Robert Burgess has a theory that it's all about expectations for inflation, the one thing that could truly decimate Strips' value. The 30-year break-even rate dropped last month to 2.07 percentage points, near the lows of the year. So-called real yields have been the force behind the move up in U.S. rates, not the prospect of accelerating price growth. That should be of some comfort to those pension funds and other long-term managers. Remember, principal-only Strips don't pay anything other than a fixed amount at maturity — it's anyone's guess about how much that will be worth in 2048 dollars.

So which came first: this unprecedented demand for Strips, or the climb in yields? And are liability-driven investors really that sensitive to a 10- or 20-basis-point move in rates? Jay Barry at JPMorgan Chase & Co. said in a note that the improving funded status of corporate pensions would naturally lead them toward fixed-income assets anyway. In another sign of ample buying power, indirect bidders (which include pensions and mutual funds) took a record high 73.8 percent share of Tuesday's $27 billion 10-year note auction. And yet yields ended higher.

That's a lot of unknowns. With Treasury yields close to multiyear highs again, getting these questions right will go a long way toward determining whether the market has scope to rally or whether these recent losses are just the beginning.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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