U.S. Treasury bonds have had a dream rally so far this year with long-dated bonds like PIMCO 25+ Year Zero Coupon U.S. Treasury Index Exchange-Traded Fund (NYSEARCA:ZROZ) adding 21.1% (as of September 12, 2016), Vanguard Extended Duration Treasury ETF (NYSEARCA:EDV) advancing over 18.9% and iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT) inching up about 12.5%.
A host of factors aided the bond market rally, defying the likely negative impact from the Fed liftoff in December 2015. Hard-landing fears in China and oil price volatility roiled the market in Q1 and an extremely shocking event like Brexit in the final month of Q2 flared up risk-off trade sentiments and boosted safe havens like Treasury ETFs. In fact, post Brexit, the yield on the benchmark U.S. 10-year Treasury note even dropped to record lows.
Dream Run of U.S. Treasury to Lose Momentum?
The spell of low bond yields seems to be turning the corner lately as rate hike talks are back with a bang. The talks, which were put back following the lackluster U.S. job, manufacturing and service sector data for the month of August, flared up lately on hawkish comments by a Fed official.
Investors should note that the Fed Bank of Boston President Eric Rosengren showed confidence in labor market strength and expects U.S. GDP growth to score above 2% over the coming two quarters. According to Rosengren, "if we want to ensure that we remain at full employment, gradual tightening is likely to be appropriate." He also noted that "a reasonable case can be made for continuing to pursue a gradual normalization of monetary policy."
All these comments stirred rate hike talks strongly on September 9. This in turn caused a carnage in the bond market with "30-year Treasuries recording their biggest two-day selloff in more than a year."
Though Fed Governor Lael Brainard offered dovish comments on the policy tightening issue on September 12, bringing the chances of a September hike to 11%, that was not sufficient to hold back uptrend in bond yields.
Bond Yields Spike Globally
Apart from the Fed, global central banks also played their role in the sudden reversal in the U.S. Treasury market. First, on September 8, the ECB refrained from giving any more stimulus and in July, Bank of Japan also did not broaden the economy's super easy money policies against many market watchers' expectations.
Speculation that BoJ could lower the buying of long-dated Japanese government bonds also had a negative impact. Bond investors figured out that there is a limitation on the central banks' easing. U.S. Treasury 10-year yields jumped to 1.68% on September 12 since it hit record lows post Brexit while German 10-year bund yields entered the positive territory for the first time since July.
As per an article published in Wall Street Journal, the 10-year Japanese government bond yield is going up toward zero, though yields of these bonds were in the negative region in most part of this year.
Are U.S. Treasuries Overvalued?
After such a steep rally, overvaluation concerns are warranted. Societe Generale SA (OTCPK:SCGLF) indicated in July that the 'fair value' for the 10-year Treasury yield is 1.95%. This suggests that U.S. Treasuries yielding 1.68% on September 12 are still overvalued, despite the recent selloff. Even Deutsche Bank (NYSE:DB) has also indicated that "a 35-year party is over for bond bulls."
So, investors may take a cautious approach while playing U.S. Treasury ETFs in the coming days. Even if the odds of a September hike are low, the Fed might agree to a 25-bps hike by the year end and then high-flying U.S. Treasury ETFs may see a slump.