Yellen has bond market in hand as volatility heads to 2015 low

[TOKYO] Janet Yellen has the bond market right where she wants it as she prepares to raise interest rates for the first time since 2006.

The Fed chair insists she expects to increase borrowing costs this year and keep the pace of subsequent increases gradual. Futures show the odds of a rate rise by December have climbed to 74 per cent from 67 per cent a week ago, even as traders take it in stride: a gauge of Treasury market volatility has declined to near the lowest this year. The gap between yields for two-year notes, which are more sensitive to monetary- policy expectations, and 30-year bonds has narrowed for seven straight days.

"Yellen's message has obviously gotten through, but the market is hardly raging away with concerns," said Hans Kunnen, a senior economist at St George Bank in Sydney. "Yes, you can raise rates, and that might push yields up a touch, but they're not going to go skyrocketing." The benchmark US 10-year note yield was unchanged at 2.32 per cent as of 12.30 pm in Tokyo, according to Bloomberg Bond Trader data. The price of the 2.125 per cent security due in May 2025 was at 98 9/32 Kunnen predicts the yield will climb to 2.6 per cent at year-end after the Fed raises rates in September. That compares with a weighted-average forecast of 2.53 per cent among analysts surveyed by Bloomberg.

The Bank of America Merrill Lynch MOVE Index, a measure of Treasury market volatility based on options trading, fell to 72 basis points on Wednesday, a level unseen since April 27. The lowest the gauge has been this year is 70 basis points on Jan 2.

"My own preference would be to be able proceed to tighten in a prudent and gradual manner," Yellen said of monetary policy in testimony before the Senate Banking Committee last week. "We also want to be careful not to tighten too late." Economists put the odds for a September liftoff at 50 per cent, according to the median of 46 responses in a July 20-22 survey.

The yield on two-year notes was 0.71 per cent, compared with 3.04 per cent for 30-year bonds. The spread narrowed to as little as 231 basis points, the least since June 2. It hasn't contracted for seven straight days since January 2014.

"The Fed will be looking to raise rates as soon as September," said Tony Morriss, an interest-rate strategist at Bank of America Merrill Lynch in Sydney. The spread between two- and 30-year yields will continue to compress at least through the end of August, and will be at 195 basis points at year-end, he said.

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