RiskApril 3, 2023

Look Out: Treasury Volatility May Not Be Over

Ongoing worries, such as the debt-limit clash, could bring it roaring back, warns Bank of America.

Reported by Larry Light

Rising interest rates, inflation, bank failures—these and other factors have sent Treasury bonds on a wild ride this year, with the biggest swings for the two-year note. While volatility has abated a bit lately, more turbulence may well recur, according to Bank of America analysts.

Reason: The troubling influences have not gone away. In fact, the looming showdown in Washington over the federal debt ceiling—which threatens to produce a default on the country’s debt—could make Treasury paper go wild again.

Brian Moynihan, BofA’s CEO, warned on CNN that a U.S. Treasury default is possible and would have dire consequences, with yields spiraling. Even if a default does not happen, bank analysts believe other forces could push yields up again. In one scenario, BofA analysts speculated that stubborn inflation and continued economic growth could pump the two-year Treasury note over 5% again.

The two-year note had the highest volatility in history in mid-March, according to the Bespoke Investment Group. Overall, the ICE BofA MOVE Index, covering the range of Treasury paper, hit a 15-year high last month.

In March, the two-year yield breached the 5% mark, a full percentage point greater than the 10-year, which is the benchmark for longer-term debt. Then the two-year, emblematic of short-term rates affected by the Federal Reserve, quickly tumbled to around 4%, just a half-point spread from the 10-year.

This has all been a trial for hedge funds that bet on yields continuing to climb.

Bad call.

Well-known trader Adam Levinson is closing his hedge fund, Graticule Asia, due to losses from ongoing bond market volatility. The fund lost more than 25% in the first two and a half months of the year.

The case for ever-rising rates is not good. The betting on the futures market is that the Fed is almost done with rate hiking and, by year-end, actually will cut rates. Propelling that narrative is that inflation appears to be on the downswing: The Personal Consumption Expenditures Price Index, the Fed’s favorite inflation gauge, rose 5% for the 12 months that ended in February, lower than the downwardly revised 5.3% gain from the end of January.

While that is nowhere near the Fed’s PCE goal of 2%, it does give encouragement to those who believe inflation is on the wane, and thus the need for the central bank to keep on hiking rates is weakening.

All this is taking place amid an inverted yield curve, which has long portended an impending recession. The two-year Treasury yield has been higher than the 10-year yield since last July amid the Fed’s tightening campaign.