By Karen Brettell
NEW YORK (Reuters) - This time, the Fed is serious.
That's the judgment of U.S. government bond investors who believe the Federal Reserve is close to paring back its $2.5 trillion, 4-1/2-year bond purchase program, and it's causing turmoil in the U.S. Treasury market.
Trading in Treasuries has turned notably more volatile in recent days and volatility may continue as traders try to adjust to a marketplace in flux.
In the last six weeks, benchmark 10-year U.S. Treasury note yields have surged to 2.19 percent, from 1.60 percent at the beginning of May.
As a result the market has seen a sharp outflow from bond funds and notable lack of demand in Treasury bond auctions. The fund outflows and the rise in volatility offer a worrying glimpse of how markets are likely to behave as the Fed works to scale back its enormous monetary stimulus of the U.S. economy.
"When you see the volumes and the movements developing in different markets, then it shows you that the transition from accommodation to tapering to eventual sideline and then subsequent tightening is going to have a lot of bumps in the road," said Steve Rodosky, head of Treasuries and derivatives trading at Pimco, which runs the world's largest bond fund.
Expectations for future volatility in the government bond market have also jumped. The Merrill Lynch MOVE index <.MERMOVE1M>, which estimates future volatility of long-term bond yields, jumped to 84.7 on Monday, its highest level in almost a year, from a multi-year low of around 50 at the beginning of May, to 79 on Thursday.
Fighting the Fed has long been seen as a losing strategy. After four years of record monetary stimulus, however, many investors are unsure of what to do when the Fed is not the primary driver of market moves.
Investors have fled from bond funds as rates rise, pulling $10.93 billion from bond funds in the week ended June 5, according to the Investment Company Institute, the biggest weekly outflow since October 15, 2008. Bond flows had previously seen inflows for 21 straight months, according to ICI.
"There is no difference in voice in the market any more. There are a few very large players and every single one of them pretty much follows the Fed, so when the Fed withdraws everyone tried to withdraw at the same time and there's no other side of the market," said Gang Hu, head of U.S. linear rates trading at Credit Suisse in New York.
At the same time, large dealer banks are less able to absorb large debt sales as new rules meant to reduce risks taken by institutions result in smaller bank balance sheets, potentially adding to price volatility. This week's quarterly auctions by the U.S. Treasury of three, ten and thirty year debt have all been notably weak.
"The ability of dealers to warehouse the shedding of risk is much more limited due to the regulatory environment, which argues for an exaggerated price move to these flows," Merrill Lynch analysts said on Wednesday in a report.
Not everyone sees a Fed pullback from its bond buying program in the near-term, especially with inflation below the Fed's target of 2.0 percent and unemployment above the target of 6.5 percent.
"The markets seems to have gotten an idea that it could be very soon; we think that's a complete misread and is very unlikely," said Michael Schumacher, head of global rates strategy at UBS in Stamford, Connecticut.
But many see the market as nearing an inflection point at which it will either become clear that the Fed's easing has put economic growth on a solid enough track to stop expanding the Fed's balance sheet, or that the benefit of further easing is outweighed by the risk of asset bubbles and market distortions.
"You've got another maybe 12-18 months of (QE) and at that point you should expect rates to go higher," said Tad Rivelle, chief investment officer of fixed income at TCW, where he helps manage $135 billion in assets.
"QE does have enormous power, but that power is not under the precise direction and guidance of the Fed. Lacking the ability to specify exactly where the excess of liquidity ultimately ends up suggests that it can leak out into emerging markets, it can run into the housing market, it can run into the equity market," Rivelle said.
The negative effects of the Fed stepping out of the market have been felt before, between the central bank's earlier quantitative easing or "QE" programs, but they were temporary as the economy sputtered anew and the Fed stepped back in. Many investors believe, however, that this time the economy is better placed to absorb the shock as the Fed stops expanding its balance sheet.
A return to a more normal level of interest rates will result in a zero total return over the next five years for investors benchmarked to the popular Barclays U.S. Aggregate Bond Index, said Zane Brown, fixed income strategist at asset manager Lord Abbett & Co LLC in Jersey City, New Jersey.
"May is a microcosm of what we might expect over the next several years because finally people did lose money in fixed income in May," Brown said.
The longer the Fed's purchases continue, meanwhile, the more difficult it may be for traders to adapt to a market without its regular presence.
"The Fed has to somehow manage to take its hand off the market and let the market function again, let the natural supply and demand function again," said Credit Suisse's Hu.
(Additional reporting by Herb Lash; Editing by David Gaffen and Clive McKeef)