Investors in US Treasuries will be closely watching a European interest rate decision next week as well as looking for further signs of how soon the US central bank may follow in raising rates. After an early sell off on Friday, in the wake of good US employment data, Treasuries ended mostly higher in price, indicating the market may pause from a two-week selloff fuelled in part by concerns the Fed may raise rates sooner than previously expected.
The European Central Bank is expected to raise interest rates when it meets next Thursday, in what would be its first hike since October 2008. The US central bank, by contrast, is not expected to hike rates until next year. Hawkish comments from some Fed members nonetheless hurt the market this week.
Two-year Treasuries, which are seen as among the most vulnerable to interest rate risk, have underperformed longer-dated debt including 10-year notes. "We've shifted into a bullish flattening and bearish flattening" pattern, said Richard Gilhooly, interest rate strategist at TD Securities in New York. "To me that's telling you that the market is pricing in a greater probability of Fed tightening," he added.
The gap between two-year and 10-year note yields has fallen to around 264 basis points from 283 basis points on March 8. Two-year notes earlier on Friday also tested support at yields of around 0.89 percent, their highest levels since last May. The notes last traded at yields of 0.81 percent. The overnight cost for dealers to obtain cash using US Treasuries as collateral, meanwhile turned negative on Friday.
Some traders attributed the negative rates in repurchase agreements to a move by the Federal Deposit Insurance Corp to charge member banks insurance fees on deposits held by the Federal Reserve, which went into affect on Friday. "We think today's move lower in repo is extreme and unsustainable," Barclays analyst Joseph Abate said in a report.
Treasuries may be supported next week by an absence of any supply auctions, the Fed's continuing bond purchases and few significant data releases. The debt also got a boost on Friday by New York Fed President William Dudley's warnings against being overly optimistic about the growth outlook.
The Fed is "looking at the impact of higher oil prices on overall economic growth as well as, in the near-term, some of the dislocations and disruptions in economic activity due to the problems in Japan," said Michael J. Materasso, senior portfolio manager and co-head of the fixed-income policy committee at Franklin Templeton.
The US government on Friday reported the jobless rate fell to a two-year low of 8.8 percent in March, though it remains higher than many Fed members are comfortable with. Treasuries may be vulnerable to further losses over time, however, if the economy remains on track and as the Fed ends its $600 billion bond purchase program in June.
A key factor to watch in June will be whether the Fed continues to invest funds from maturing mortgage-backed securities into Treasuries, said TD's Gilhooly. "When the Fed starts rolling off MBS they are tightening policy," he said. Five-year notes rose 5/32 in price on Friday to yield 2.25 percent, down from 2.27 percent on Thursday, and 10-year notes rose 6/32 in price to yield 3.45 percent, down from 3.47 percent. Thirty-year bonds rose 11/32 in price to yield 4.49 percent, down from 4.51 percent.
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