The Most Significant Day For Bond ETFs

Two events are set to take place next week, with potentially major ramifications for fixed-income ETFs.

The seemingly never-ending bull market in bonds has taken a pause in recent weeks, jolting financial markets that had grown accustomed to ever-lower interest rates.

Japan's 10-year bond yield briefly reached zero on Monday, the highest level since March (bond prices and yields move inversely). Japanese bonds have been selling off ever since late July. That's when the Bank of Japan (BoJ) said it would conduct a "comprehensive assessment" of policy at its Sept. 21 meeting, fueling concerns that the central bank had reached the limits of monetary stimulus.

Japan 10-Year Bond Yield

In the past month, confusion has reigned over what the BoJ meant, with some analysts speculating that the central bank might tighten policy by capping bond purchases.

"The turnaround in JGB yields ... suggests that the bond markets are beginning to discount no further negative deposit rate cuts," said Jefferies analysts led by Sean Darby. "A more sinister view of the reversal in JGB prices is that the markets have begun to realize that the 'frontier' in QE policies is drawing to a close. In particular, there is the growing reality that the BOJ may be set to taper JGB purchases at the forthcoming BOJ meeting."

On the flip side, others insist that the BoJ's highly accommodative policies aren't going to change, and that rates will revert to lower levels soon.

“The BOJ hasn’t wavered in its judgment that quantitative-and-qualitative easing with a negative interest rate has reduced real yields,” Naomi Muguruma, a senior market economist at Mitsubishi UFJ Morgan Stanley Securities, told Bloomberg. “We’ll return to stable, low levels for yields amid extreme supply-and-demand conditions in the market.”

With so much uncertainty about the central bank's intentions, the BoJ's Sept. 21 policy decision is sure to be a big market mover for Japanese bond markets, with potential ramifications for other markets in Japan as well as globally.

2 Big Central Bank Decisions On Sept. 21

Sept. 21 is a day that will be significant not just due to the BoJ decision. Coincidentally, the Federal Reserve will announce a monetary policy decision of its own on that day, and there are a growing number of traders who believe the U.S. Central Bank may also make a move at that time.

On Friday, Fed funds futures markets were pricing in a 30% chance of a rate hike this month. The probability of a hike by the December meeting was even higher, at 60%.

Comments by Boston Fed President Eric Rosengren late last week sparked a notable uptick in rate hike expectations and long-term bond yields, while simultaneously spurring a huge sell-off in U.S. equity markets.

Rosengren―a voting member of the Federal Open Market Committee this year―said that "gradual tightening is likely to be appropriate." He added that “a failure to continue on the path of gradual removal of accommodation could shorten, rather than lengthen, the duration of this recovery.”

While not necessarily a novel view, the fact that Rosengren didn't temper his sentiments following recent tepid economic data on jobs and services led some to believe that a rate hike is coming sooner rather than later.
 

On Monday, Fed Governor Lael Brainard, another voting member of the FOMC, warned against raising rates too quickly. That led to a rebound in equity markets, but didn't spur much of a recovery in bonds, which continued to anticipate a hike sometime this year.

Yields on the 10-year bond were last trading at 1.67% on Monday after reaching as high as 1.7%, the loftiest level since June 24―the day that “Brexit” results were announced. Yields are up 35 basis points since they set a record low at 1.32% on July 6.

U.S. 10-Year Bond Yield

ETF Impact

ETFs tied to fixed income―one of the most popular areas for investors this year based on flows―have been performing poorly as yields have risen.

Some of the biggest funds in the space, such as the iShares Core U.S. Aggregate Bond ETF (AGG), the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), the iShares U.S. Preferred Stock ETF (PFF) and the iShares 20+ Year Treasury Bond ETF (TLT), are down anywhere from 0.4% to 2.9% so far this month, as can be seen from the chart below:

September Returns For AGG, LQD, PFF, TLT

With fixed-income ETFs doing well for so long, even these relatively modest losses stand out.

That said, there have been plenty of head fakes when it comes to interest rates. It remains to be seen whether this is merely a pause in a long bull market in bonds or the beginning of the end, but in either case, Sept. 21 stands out as the most significant date for the asset class so far this year.

Contact Sumit Roy at [email protected].