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Rates market sleepwalks back towards historically low yields

New York

THE Treasury market is sedated, and it's hard to find anyone who thinks yields will do anything but shuffle along or sink further.

A measure of expected volatility for the next month hit a historic low last week after the Federal Reserve pledged to keep its policy rate at zero until inflation is "moderately above 2 per cent for some time". The depressed levels of long-end yields suggest investors aren't concerned about that happening any time soon: The 10-year rate has been stuck in a range of barely 10 basis points all month, and is less than 40 basis points above its record low.

Markets could get choppier in the months ahead, given the tenuous chances of another fiscal stimulus deal and possible fallout in economic data and equity markets, says PGIM Fixed Income's Michael Collins. He expects these risks to favour further rallies for long-dated Treasuries. In his view, the window of opportunity for higher yields, after the Fed flagged its new stance on inflation at its annual conference last month, appears to have closed.

"Right after Jackson Hole, the market tried to sell the back end of the Treasury curve, and all of those trades are out of the money," the portfolio manager said. "The Fed's messaging is locking down rates and locking down rate volatility potentially for several years."

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It's hard to see anything game-changing coming out of this week's Congressional testimony, when Fed chairman Jerome Powell and Treasury Secretary Steven Mnuchin will discuss their pandemic relief efforts. The testimony is likely to focus on adjustments to the Main Street Lending Program that has dispensed only a fraction of its US$600 billion of emergency funds for smaller businesses and non-profits. Mr Powell is unlikely to add much detail to the policy stance he presented in the press conference, and lawmakers have failed to compromise on further stimulus after months of talks.

Looking ahead, the Nov 3 election could shatter the rates-market calm. Options on the rates volatility index spanning the next three months are pricing the vote as one of the biggest isolated event risks in more than a decade. These trades are bracing for the risk that a flood of mail-in ballots due to the pandemic may leave the winner undeclared for days or weeks.

"The market is underpricing the chance of a contested election and how that will impact valuations," said Lisa Hornby, a portfolio manager at Schroders, who is staying neutral on Treasuries and focusing on opportunities to buy corporate credit on bouts of weakness.

In the meantime, a surprise agreement on a stimulus package or news on trials for a Covid vaccine are the main potential catalysts for a breakout in yields. Otherwise, this low-volatility environment is likely to draw the long end of the curve gradually lower.

With the help of the upcoming quarter-end index rebalancing, says Stifel Nicolaus & Co's Chris Ahrens, the 10-year yield could sink back towards its August trough around 0.50 per cent, from the current 0.70 per cent. Its all-time low of 0.31 per cent came amid the turmoil of March.

He also expects the low volatility to weigh in favour of a flatter curve.

"What I feel most comfortable about right now is taking duration, because the Fed has told me they're not doing anything with the policy rate for at least three years and the market seems to have bought that," he said. BLOOMBERG

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