Investors remain cool to increase in Treasury yields

Yields on 10-year U.S. Treasuries hit a 2016 high in the days following the U.S. presidential election, but asset owners won't be boosting bond allocations just yet.

Their reasoning: It's unclear whether higher yields are here to stay.

The 10-year U.S. Treasury yields surged 40 basis points in the week ended Nov. 18 to 2.3%, rising to close at 2.35% on Nov. 23, the highest level this year, as markets evaluated the impact of U.S. President-elect Donald J. Trump's upset and expectations of rising interest rates and inflation.

Bern-based David Engel, portfolio manager at the 36.5 billion Swiss franc ($39.9 billion) Swiss Federal Pension Fund PUBLICA, which as a collective comprises 20 pension funds, said: “Generally higher yield is positive for the overall fund, including liabilities. (Nevertheless) our strategy hasn't changed,” he said.

“Since Mr. Trump hasn't even taken up office yet, we consider the current move to be a market overreaction and therefore bond prices to at least stabilize in the foreseeable future, before they start to fall, due to higher inflation expectations and a more hawkish attitude from the (U.S. Federal Reserve),” said Arnd Sieben, Munich-based, CIO of BayernInvest Kapitalverwaltungsgesellschaft.

Fiscal measures touted by Mr. Trump, including big tax cuts and increased infrastructure spending, solidified the expectation among global managers that the Fed will increase rates at its next meeting in mid-December.

Asset owners and money managers say they have anticipated these developments. The fact that bond yields are going up at this point in the economic cycle did not surprise them as much as the fact they did so soon after Mr. Trump's victory.

Mr. Sieben, whose capital management company, KAG fund, BayernInvest is part asset owner and part manager, said he doesn't expect institutional investors to immediately tune asset allocation in favor of bonds.

“Those (investors) that need to serve regulatory requirements are limited and those that need to meet nominal liabilities will have to wait for even higher yields to occur,” he said.

Luiz Cardosa, CIO of the $1 billion Nucleos-Instituto de Seguridade Social, Rio de Janeiro, agreed with Mr. Sieben.

“We believe rates have to go up before institutional investors come back to the market.”

Mr. Cardosa said the impact of Mr. Trump's election was “that our yield curve was lifted because of expectations that he may implement a more active fiscal policy increasing government expenditures.”

He added “the central bank (in Brazil) has just started to reduce the short-term rate last month, therefore we will not move any money to U.S. 10- or 30-year Treasuries.”

David Morton, chief market strategist at Rocaton Investment Advisers LLC based in Norwalk, Conn., said “some asset owners with long-term views see elevated yields as an opportunity to reinvest cash flow at a higher rate ... definitely a positive development for asset owners.”

In a rising rate environment, asset owners and asset management firms are operating in a short-term mode, preparing for the incoming president's first moves. Some global managers said they believe Mr. Trump's election potentially put an end to very low interest rates and that the expected fiscal stimulus will force the U.S. central bank to accelerate the pace of future monetary policy decisions. According to them, the Fed will hike rates at least once in 2017.

David Long, senior vice president and CIO, asset liability management, derivatives and fixed income at the $63.9 billion Healthcare of Ontario Pension Plan, Toronto, said “rates can probably rise from here both in U.S. and Europe.”

“As rule of thumb, if there is a market expectation of an interest rate hike, markets generally don't react but if there is an expectation and there is no hike — then we could see a different reaction.

“Twenty-five basis points on Fed funds in December is today's expectation,” he said.

There also is uncertainty about whether Mr. Trump will be able to carry out his reforms. From long-term investors' point of view, the steepening of the yield curve in the short term does not alter the wait-and-see strategy.

Rocaton's Mr. noted that an increase in interest rates by the expected 25 basis points doesn't matter for 10-year and 30-year Treasury curves.

Still, observing yields go up globally, European institutional investors might begin to tweak portfolios.

As U.S. Treasury yields pull the trajectory of German bund yields upward, European asset owners agree they have gone up due to fundamentals, not only because of Mr. Trump's election.

Stockholm-based Par Magnusson, senior rate strategist, at Swedbank said, “Short term we expect a steeper U.S. curve relative to Germany and Scandinavia, while seeing a potential for the spread to widen between 10-year U.S. Treasuries and other safe-haven sovereigns.”

BayernInvest's Mr. Sieben said, “We recommend a USD long position and to slightly shorten duration.”

Elevated yields have also delayed the prospect of tapering by the European Central Bank, with some managers saying it is now almost certain to extend QE beyond its current schedule.

According to Leon Cornelissen, chief economist of Rotterdam-based Robeco, elevated bond yields mean more eligible instruments are available in the marketplace for the ECB to purchase. “It is now most probable that (ECB President Mario) Draghi will extend the QE because any tapering would push yields higher up,” he added.

According to Stephan Hirschbrich, head of global rates at Union Investment in Frankfurt, yields of 10-year U.S. government bonds will be at 2.8% by the end of 2017 and 10-year German government bonds will be at 0.6% yield, compared with the present 0.35%, he said.

“QE extension should also set a limit to price losses,” he said.

Volatility is expected to continue to be a theme in the coming months.

The Italian referendum on Dec. 4, centering on constitutional reform, could bring tapering back into the mix, managers said.

Another big unknown: The outcome of 2017's presidential election in France. Polls suggest far-right leader Marine Le Pen is expected to make it to the final run-off in May.

“Should Le Pen win the French election all bets are off and we could see a massive flight to quality in the bond market,” said Mr. Magnusson.