Fresh test for US bond market 

THE US bond market could face another bout of volatility as rising Treasury yields, heavy corporate borrowing and hedging activity threaten to reinforce the latest sell-off.

With long-term borrowing costs already at levels not seen for more than two decades, investors will be watching whether buyers step in to take advantage of the higher yields or stay on the sidelines as the pressure builds.

As it stands, several technical indicators seem to suggest the sell-off could intensify, potentially creating a feedback loop in which rising yields trigger more selling and further increases in borrowing costs, according to a recent Reuters report.

However, there is also a case for investors to return to the market, with yields offering some of the most attractive entry points in years.

“People in the market are recalibrating their expectations,” Dustin Reid, fixed income strategist at Mackenzie Investments, told Reuters.

US Treasury yields have climbed sharply since the war with Iran began in February, with both the 10-year and 30-year yields rising by more than 100 basis points (bps) to their highest levels in over two decades amid the recent sell-off.

The concern now is whether the market is approaching a tipping point, where selling becomes self-reinforcing rather than simply reflecting changing expectations for interest rates and inflation.

Reuters identified four warning signs that investors should monitor as the market heads into the coming weeks. These are rising volatility in the options market, a surge in corporate issuance to fund the artificial intelligence (AI) buildout, increased hedging by mortgage investors and a steepening spread between 10-year and 30-year US Treasury yields.

Demand for protection

There is rising demand for protection against higher interest rates. In the options market, this is reflected in what is known as the “payer skew”, which allows investors to protect their portfolios against a sharp rise in yields without having to sell their Treasury holdings.

Demand for short-term protection against a jump in 10-year US swap rates has intensified, Reuters has reported.

The cost of insuring against a 200-bps rise in rates over the following three months reached 132 bps last Monday, the highest since the March 2023 banking crisis triggered by the collapse of Silicon Valley Bank.

Although these options are linked to swap rates rather than Treasury yields, the two generally move together. The increase in hedging, therefore, points to growing concern that long-term borrowing costs could climb further.

Another source of pressure is the AI infrastructure boom, which is driving substantial corporate borrowing.

Investors told Reuters that a surge in bond issuance to finance AI infrastructure has contributed to the Treasury sell-off. Although credit spreads have remained tight, buyers of longer-dated bonds issued by large AI companies are hedging their exposure to interest-rate movements through the government bond market.

These transactions can result in Treasury futures being sold, adding to downward pressure on bond prices and pushing yields higher. Some investors also sell government bonds outright to make room in their portfolios for higher-yielding corporate debt.

“When a transaction prices midday, in the afternoon everyone is selling Treasury futures,” Neil Sun, portfolio manager at RBC BlueBay Asset Management, who focuses on investment-grade credit, told Reuters.

The scale of planned borrowing suggests this pressure may persist. Goldman Sachs expects major cloud computing companies, known as hyperscalers, to issue a record US$420bil in debt next year, potentially creating further demand for hedging and additional selling of government securities.

Movements amplified

Mortgage-related hedging is another factor that could amplify market movements, Reuters notes.

As interest rates rise, the expected life of mortgage-backed securities lengthens, leaving investors more exposed to further increases in yields. They typically respond by increasing their interest-rate hedges, a process known as convexity hedging, which can involve selling Treasury futures.

“The market is carrying a substantial cohort of mortgages originated over the past three years at coupons relatively close to current mortgage rates,” Mike Riddle, chief executive officer of Chicago-based Eris Innovations, a futures and options products developer, tells Reuters.

That leaves room for more hedging as rates move, while nine large trades this month indicate that mortgage investors have been scrambling to protect their positions.

The fourth warning sign is the steepening of the 10-year/30-year Treasury yield curve, which suggests investors are demanding greater compensation for holding longer-dated government debt.

The spread between the two yields widened to about 37 bps last week, as the 30-year yield rose faster than its 10-year counterpart. While the spread has been wider before, including when it reached 52 bps in late July, the latest move is taking place with yields already near multi-decade highs.

This suggests investors may be demanding a higher term premium, or additional compensation for holding long-term debt, rather than simply adjusting their expectations for the US Federal Reserve’s interest-rate policy, according to Reuters.

Fiscal concerns could also weigh on demand for longer-dated Treasuries as investors question the US government’s long-term borrowing outlook.

“There’s just more interest in the 10-year than the 30-year on the part of investors, who see there’s much more potential for things to go wrong in the fiscal picture in the United States over the longer time frame,” says Alex Morris, co-founder of fixed income asset management firm F/m Investments.

“Essentially, people are telling the Treasury, ‘I don’t know if you guys have got this under control,’” he tells Reuters.