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Fixed income

Soaring yields take heavy toll on investors Add to ...

Bond yields have just experienced one of their sharpest rises in years, roiling everything from Canadian stocks to gold.

The yield on the bellwether 10-year U.S. Treasury soared to 2.6 per cent during frenzied trading Monday, compared with levels around 1.6 per cent at the beginning of May.

An increase of nearly one percentage point in two months is considered highly unusual in the fixed-income market. Coming at the same time as signs of instability in the Chinese money market, the soaring yields have many investors pushing the panic button.

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Bond yields and prices automatically move in opposite directions, so the rise in yields has produced huge losses in bonds, and led to a record flight out of fixed-income securities as investors try to dump their holdings to protect themselves.

Rising yields are also a threat to stocks, because higher interest rates imply heftier borrowing costs for companies, which could hurt earnings. Higher yields also increase the attractiveness of bonds in comparison to gold, which pays no dividend.

But many analysts believe the rise in rates, to the highest level in nearly two years, may be overdone, and wouldn’t be surprised to see levels fall back, at least over the short term.

Kent Engelke, chief economic strategist at Capitol Securities Management Inc., a Virginia-based brokerage firm, says the wave of bond selling has “just gone too far too quickly.”

According to TrimTabs Investment Research, investors are selling bond-related investments at a record pace, with $47.2-billion (U.S.) flowing out of U.S. bond mutual funds and exchange-traded funds so far in June, easily exceeding the record of $41.8-billion set in October, 2008, during the financial panic.

Other major bond markets, including Canada’s, have also felt similar selling pressure. The yield “everywhere around the world is rising,” observes Mark Chandler, head of Canadian fixed-income strategy at RBC Dominion Securities Inc.

Analysts say the explanation for the rate move is fear that the U.S. Federal Reserve will soon start to scale back the extraordinary monetary stimulus it has been adding to the financial system to keep yields low.

The Fed has been purchasing $85-billion a month of Treasuries and mortgage-backed securities with newly created money. Fed chairman Ben Bernanke said last week that if the U.S. economy continues to mend, the central bank will start to taper its buying.

As Mr. Bernanke’s comments suggest, the rise in rates is partly a good news story, because it reflects a better economy that may not need exceptional amounts of monetary stimulus. In normal times, central banks purchase securities, but on nowhere near the scale that has occurred since the financial crisis.

“I believe that American growth in general is starting to accelerate, and that is the reason why Treasuries are selling off,” Mr. Engelke said.

He added that the move in bond yields has been so sharp that he believes the market is “oversold,” a term traders use to describe conditions where there has been so much selling that any bit of buying or good news is likely to prompt a sharp counter rally. He says he wouldn’t be surprised if yields drop back to 2.15 per cent to 2.25 per cent on the 10-year Treasuries, at least over the short term.

Longer term, Mr. Engelke believes the three-decade rally that has propelled bonds to higher and higher prices – and progressively lower yields – since 1981 may be ending.

Although he doesn’t see yields soaring back to the levels of 7 per cent that were once common, he said 10-year bonds could ultimately yield around 4 per cent, which has been a long-term average during periods of low inflation.

Few analysts expect the Fed to allow yields to soar to levels that might choke off the economic recovery.

Forecasting and consulting firm Capital Economics projects that 10-year yields could slowly creep up to 3 per cent next year and 3.5 per cent by the end of 2015.

“If the Fed thinks that the recent rise in long-term interest rates is threatening the recovery then it will presumably add more stimulus,” Paul Ashworth, chief U.S. economist at Capital Economics, wrote in a note to clients.

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