Fed-induced bond selloff could turn into a global rout

LONDON Wed Sep 11, 2013 3:16pm EDT

LONDON (Reuters) - The global spillover from the selloff in U.S. Treasuries has buffeted investors in top-rated governments bonds from Australia to Sweden with more to come if world growth picks up steam.

Low-risk bond prices have been hammered as the strength of the U.S. recovery convinces many that the Federal Reserve will soon start to trim its $85 billion of monthly liquidity injections, causing large losses for investors.

U.S., Canadian and German bonds are down more than two percent on a total return basis for the year to date, according to Citi's latest world government bond index.

If core fixed income markets end this year with losses, it will be only the third time this has happened in the last 33 years, said major bond investor BlackRock.

"Basically avoid fixed income as much as you can, allocate to equities, allocate to cash," said Christoph Kind, head of asset allocation at Frankfurt Trust, which manages 16 billion euros ($21 billion) in assets.

A move to cut bond purchases by the Fed and the rise in bond market rates should make bank shares more attractive in particular.

Banks enjoy a bigger margin between the interest they earn on loans and the interest they pay for deposits when rates are higher, though the transition to higher rates can be painful, since bank loans can have fixed interest rates over long periods of time, whereas deposits tend to re-price more quickly.

UNIFORM RATE RISES

Yields on benchmark U.S. Treasuries have surged by 1.5 percentage points from lows around 1.6 percent in May to top 3 percent for the first time in just over two years.

The equivalent British yields have jumped by a similar amount over the same period to just above 3 percent. German yields rose almost a percentage point to top 2 percent for the first time in 18 months.

The sharp moves have come even as major central banks - the Fed, the European Central Bank and the Bank of England - have signaled that official interest rates will stay at record lows at least for the next couple of years.

Most of the moves are accounted for by a return to more normal levels to reflect a recovering global economy rather than a change in central bank rate expectations. This suggests there might be little central banks can do to fight the trend, Deutsche Bank strategists say.

It also raises the potential for an overshoot in yields, especially if the pace of economic recovery beats forecasts or the Fed reduces its bond purchases more sharply than expected.

Out of nine developed markets, no bond risk premium has yet returned to its 1997-2012 average even though yields have risen sharply since the start of this year, Deutsche Bank said.

"Treasury and gilt yields still remain around 50 basis points below where a normalized bond risk premium would suggest, while Bunds are even more expensive with another 70 bps still to go," said George Saravelos, head of European FX and cross-market strategy at Deutsche Bank.

Yields in other top-ranked bond markets were around 100 bps below 'normal', implying plenty of scope for normalization, according to Saravelos, who said Scandinavian and Swiss markets, where prices have fallen more modestly since May than in other developed markets, could have further to run.

"One has to distinguish between cause and effect. Global bond yields are rising due to a normalizing business cycle and reduced tail risk, so they are the outcome of better growth, rather than likely to impede it," Saravelos said.

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Euro zone bond returns: link.reuters.com/fuf92v

Asset returns since Fed's tapering hint:

link.reuters.com/wej98t

Fed assets, QE and GDP: link.reuters.com/cew62v

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TIGHTENING FEAR

Nevertheless, the surge in global bond yields is raising concern among European policymakers mindful of the bond markets crash triggered in 1994 when the Fed started tightening policy.

"If spill-overs were large in 1994, we can expect them to be even larger today in an even more deeply interconnected world," ECB policymaker Jorg Asmussen said in Brussels on Tuesday.

While the euro zone's weaker southern economies have escaped the sharp backup in yields to date, cyclical shifts in core long-term rates could delay or even damage the heavy debtors' ability to manage much needed fiscal reforms.

"Normalizing Treasury yields has to be done carefully because it will dislocate other asset classes, and put serious stress on the underlying economy," said Bill Street, head of investments, EMEA, for State Street Global Advisors.

"If you start getting north of four percent for (Treasury) yields any time soon, you are going to have problems in the real economy," he said. "Four percent is not out of the realm of possibility at some point in 2014."

($1 = 0.7518 euros)

(Graphics by Vincent Flasseur and Marius Zaharia; Editing by Ruth Pitchford)