By Julia-Ambra Verlaine
Yields on U.S. government bonds fell to new lows and stocks
dropped Friday after a better-than-expected jobs report failed to
assuage growing investor fear over the global coronavirus
crisis.
The yield on the benchmark 10-year Treasury note, a key
reference rate for borrowing costs throughout the economy, fell for
a 12th consecutive session to close at a new all-time low of
0.709%. The yield regained some ground as stocks pared losses in an
end-of-trading recovery.
That move upward wasn't enough to push the Dow Jones Industrial
Average into positive territory for the day. But the index did post
a slight gain for the week, a period marked by violent swings as
investors gauged the progression of the coronavirus and a surprise
rate cut of a half-percentage point by the Federal Reserve.
The Dow ended Friday down 1%, at 25864.78, paring what at one
point earlier in the day had been a drop of more than 800 points.
The blue-chip index has still fallen around 9% since the start of
the year. A sharp drop in the price of oil hit energy stocks, while
investors also punished bank shares.
Analysts and investors said a muted response to Friday's monthly
jobs report, which showed employers adding more positions in
February than expected, occurred because companies reported their
headcounts before cases of coronavirus began mounting in the U.S.
Many investors already expect the Fed to cut its short-term
benchmark rate again by its March 17-18 meeting at the latest.
While stocks garnered much of the investing attention during the
week's tumult, equally dramatic moves occurred in bond markets.
Treasury yields, which fall when bond prices rise, plunged in
overnight trading before the jobs report. Investors intensified the
rush to safer assets and anticipated lower short-term rates for the
foreseeable future as the economic fallout from the virus spreads
with each canceled flight and shuttered factory.
Adding fuel to the yield decline: the insatiable demand of major
U.S. banks, whose hedging needs have risen with each fresh decline
in rates.
Banks need to buy around $1.2 trillion of 10-year Treasury notes
to offset risks on mortgages and bank deposits, according to
JPMorgan research estimates. Commercial banks own around $3
trillion of U.S. Treasury and government-agency securities, Fed
data show.
The 10-year yield, which helps set borrowing costs on everything
from mortgages to business loans, has been pushed lower by worries
about the coronavirus's potential impact on the economy, which
resulted this past week in the Fed's first emergency rate cut since
the financial crisis.
The yield has declined precipitously from 1.90% at the beginning
of the year. The plunge both reflects and intensifies commercial
banks' efforts to manage balance-sheet risks including sensitivity
to interest-rate swings. This practice, known in industry parlance
as convexity hedging, has been a significant factor in the bond
market for years but has become even more momentous as a result of
tighter rules adopted after the 2008 crisis.
"Convexity tends to exacerbate market moves -- if rates are
going lower, convexity will make the move sharper," said Gennadiy
Goldberg, U.S. rates strategist at TD Securities.
Here is how it works. When interest rates fall, many homeowners
who took out fixed-rate mortgages refinance to lock in lower
monthly payments. The owners of the relevant mortgages and
mortgage-backed securities -- including the banks -- lose out on
higher payment streams. As a result, the prices of mortgage bonds
tend to rise less in any given bond rally than Treasury securities
or some other bonds, making them "negatively convex."
Banks hedge their holdings of mortgages and other assets to
limit these sorts of losses, but doing so often entails buying new
assets including Treasurys. Banks also use interest-rate
derivatives to offset potential losses from changes in rates --
usually swaps, in which the bank typically exchanges the right to a
fixed payment for a floating payment under specified terms.
The sharp decline in rates is making banks even bigger buyers of
Treasurys, as the probability of mortgage refinancing increases and
they seek to bridge expected income shortfalls generated when
higher-paying fixed-income securities "prepay," as traders say when
refinancings enable a bond to be paid off early. The same dynamic
plays out to some extent with deposits, which are liabilities that
the banks seek to match with assets, a match that often comes under
pressure when the rate environment changes significantly.
The three largest U.S. banks by assets, JPMorgan Chase &
Co., Bank of America Corp. and Wells Fargo & Co., have steadily
grown since the financial crisis, expanding their mortgage books
and raking in more consumer deposits through money-market, checking
and savings accounts. That means bigger hedges to manage risks.
JPMorgan held an average of $215 billion of residential
mortgages on the books at the end of 2019, compared with $143
billion a decade earlier. Wells Fargo deposits climbed to $890
billion last year from $787 billion in 2016. Interest-bearing
deposits at Bank of America jumped nearly 20% over two years to
$900 billion in 2019.
Partly as a result of larger mortgage and deposit balances, both
of which can require hedging, banks have grown more sensitive to
rate changes. JPMorgan research analysts estimate the expected
increase in net interest income for banks for a 1-percentage-point
increase in rates is $8 billion, up from $6 billion last year.
Those figures generally work in reverse when rates fall.
This sensitivity can be painful when banks misjudge the economic
outlook or market sentiment. In 2018, many large banks were
wrong-footed by the year-end market meltdown that ended in the
Fed's decision to begin cutting rates following several years of
increases.
The scale of these moves and the ripples from banks' efforts to
hedge them underscore the tightrope the Fed is trying to walk as it
seeks to keep the economy on track in the face of rising
coronavirus fears.
"If the Fed overreacts and cuts too much, it creates other
dynamics that hurt insurance companies, pension funds and the
banking system," said Rick Rieder, chief investment officer of
global fixed income at BlackRock.
Compounding the problem, banks are hamstrung by postcrisis
capital rules that have made assets including corporate bonds
expensive to hold, making it difficult for them to buy assets with
long duration that they can carry on the balance sheet.
Accordingly, they are now buying products long preferred by
insurance companies, including collateralized mortgage obligations
-- financially engineered mortgage bonds sold in grades that can
make higher-rated ones less vulnerable to prepayment risk -- in the
hunt for longer-lived assets that they can hold.
"This rally has exacerbated an already significant issue," said
JPMorgan's head of U.S. interest-rate-derivatives research, Josh
Younger.
Write to Julia-Ambra Verlaine at Julia.Verlaine@wsj.com
(END) Dow Jones Newswires
March 06, 2020 18:30 ET (23:30 GMT)
Copyright (c) 2020 Dow Jones & Company, Inc.
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