With the Fed assembly looming, buyers brace for larger authorities bond yields in 2021

© Reuters. FILE PHOTO: The Federal Reserve on May 1st in Washington

By Kate Duguid and April Joyner

NEW YORK (Reuters) – Investors are betting that longer-term Treasury bond yields will rise in the short term, reflecting expectation that the Federal Reserve is unlikely to reconfigure its purchases at its Wednesday meeting to stem any spike in longer-term yields.

The spread between two- and ten-year Treasury yields, the most common measure of the yield curve, has increased in recent months, increasing by more than 10 basis points in December alone. Bearish bets on longer-term government bonds are near record breaking in the futures markets, while options investors have also accumulated positions that would benefit if yields rose.

A survey by Bank of America (NYSE 🙂 Global Research on Wednesday found that a record 87% of fund managers expect higher returns over the long term, while a record of 76% expect a steeper yield curve.

"We believe interest rates will rise next year," said Blake Gwinn, US interest rate strategist at NatWest Markets. "I'm in the steeper camp for the rest of 2021."

Expectations that a vaccine against COVID-19 will result in widespread store openings and spur economic growth has led investors to sell safe government bonds in favor of comparatively riskier assets like stocks. This has increased the yields on government bonds, especially long-term bonds, reflecting investors' growth expectations over a longer period of time. Even so, yields remain low by historical standards after hitting an all-time low in March.

Recent bets on a steepness show that the Fed is unlikely to cap any hike in yields this week by shifting its bond purchases to the long end of the curve, an instrument known as Operation Twist. Increasing returns can increase borrowing costs for businesses and individuals.

"We are definitely in the minority view," said Gennadiy Goldberg, US interest rate strategist at TD Securities, who believes the Fed will announce an increase in longer-term government bonds tomorrow.

Only a fifth of 43 economists in a recent Reuters poll expect the Fed to step up stimulus at its December meeting.

However, some investors believe that a vaccine-induced surge in economic growth could test the Fed's framework over the next year by pushing yields higher.

Goldman Sachs (NYSE 🙂 expects the 10-year Treasury yield to end at 1.3% next year, down from 0.911% Tuesday. Analysts at Deutsche Bank (DE 🙂 forecasts an increase to 1.5% by late summer 2021. Charles Schwab (NYSE 🙂 expects yields to trade in a range between 1% and 1.6%.

A spate of so-called steeper trades, betting that the long end of the yield curve will rise faster than the short end, is evident in the steeper spreads of five years, 30 years and three months, ten years spread.

The bets are also showing in the options markets, where contracts for 10-year treasury put options are built in February and March and the number of open contracts for some February options increases by more than 10,000 in the first week of this month. Treasury put options are typically used to position a decline in bond prices.

Options on exchange-traded Treasury-focused funds reflect higher expectations for volatility. The implied volatility for March protects against a 10% drop in price for the iShares 20+ Year Treasury Bond (NASDAQ :). The ETF has risen to a high for the year, wrote Amy Wu Silverman, equity derivatives strategist at RBC Capital Markets, in a note to clients last week.

The discrepancy between what the Fed says and what investors expect could be one of the triggers for such a move in the next few months, said Bruno Braizinha, interest rate strategist at BofA Global Research.

"If the Fed says something that doesn't align well with the market, the move will likely result in higher returns than lower returns," he said.

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