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Investor flight from U.S. stocks fails to lift bond market

A trader works on the floor of the New York Stock Exchange shortly after the market opened in New York September 1, 2015. REUTERS/Lucas Jackson

By Gertrude Chavez-Dreyfuss NEW YORK (Reuters) - The "flight to safety" into bonds many expected when U.S. stocks slumped last week never took off, making big losers out of prominent fund managers and further confusing investors at a volatile time in the market. Stocks plunged in the second half of August, largely on fears of China's worsening economy, but U.S. Treasury yields did not see the kind of safety bid that many were expecting and has been typical in times of stock-market stress in the past. Strategists link the lack of a move to bonds to a number of events: Hawkish rhetoric from Fed officials even as the equity market stumbled; a bout of selling by hedge funds that had expected a rally in the bond market that they didn't get; and bond sales by central banks in China and other emerging market economies trying to protect their currencies from depreciating. Reduced appetite from overseas, along with the outlook for the Fed, will be crucial in coming weeks if equities fall again and bonds don't respond. The Fed decision on September 17 could mark the first rate increase in almost a decade, and uncertainty surrounding that decision is likely to keep many in the bond market on the sidelines. "The correlation between bonds and stocks is more situational now because it's the central banks calling the shots," said Robert Vanden Assem, head of developed markets investment grade fixed-income at PineBridge Investments in New York. During the recent U.S. stock market sell-off in the third week of August, for instance, the S&P 500 <.SPX> dropped 9 percent, but U.S. 10-year Treasury yields, which move inversely to prices, fell by only 12 basis points. That's not typical. According to Bank of America Merrill Lynch, the relationship between stocks and bonds that has held since 2009 suggests 10-year yields should have declined by 22 basis points. Bond yields since then have drifted higher and buying interest has been minimal. The lack of a rally in the U.S. Treasury market made big losers out of notable hedge funds, including Bridgewater Associates' All-Weather Fund, which fell 4.2 percent in August. These funds borrowed heavily to augment their returns, but as things became turbulent, that leverage generated losses that forced them to wind down that borrowing. Strategists say part of what kept Treasury yields from reflexively falling through a run to safe-haven debt were hawkish signals from the Fed, particularly Fed Vice Chair Stanley Fischer. At last week's central bank gathering in Jackson Hole, Wyoming, several Fed officials, including Fischer, seemed to boost the odds on a rate increase if not in September, then certainly in December. The message the Fed delivered over the weekend came between a Friday and Monday that saw the U.S. Standard & Poor's 500 lose 7 percent of its value. Leading brokerages, including Citigroup and Bank of America, commented that though it's a close call, the odds favor an increase in the next few weeks. "Unless the U.S. economy shows signs of slowing, the bond market is likely to keep yields relatively firm," said Alan Gayle, director of asset allocation at RidgeWorth Investments, even if the S&P 500 falls in the weeks ahead on concern about growth in China and other emerging market economies, he said. Interest rate futures this week saw a more than 50 percent chance of a rate hike in December and a 28 percent probability in September , according to CME Group's FedWatch program. If that happens, bonds won’t look as attractive. Higher interest rates diminish the value of an investor's bond holdings, resulting in lower portfolio returns. "Treasuries have been a good diversifier to portfolios, but their benefit as a diversifier has been reduced because yields are already extremely low and the Fed is starting to normalize rates," said Rick Rieder, chief investment officer of fundamental fixed income at BlackRock in New York. CHINA, CURRENCY INTERVENTIONS Further supporting yields on U.S. Treasuries was the sell-off in reserves by China and other emerging market economies to shore up their slumping economies. U.S. Treasuries represent the bulk of the Chinese and emerging market reserves. Fears over weakened growth prospects and plunging commodity prices in some emerging markets have taken a toll on their currencies. As China sold currency reserves in recent months, real yields have moved higher since the beginning of the year, while inflation expectations have declined. China and emerging markets led the build-up in global foreign exchange reserves following the 1997 Asian crisis to a peak of $12 trillion last year. This cash pile shielded them from the 2007-08 crisis, and it looks as if it is once again being deployed. It's not clear whether China has sold U.S. Treasuries over the last month, or if so, how much. Bank of America Merrill Lynch speculated in a research note that if China sold between $7 billion to $10 billion a day of U.S. Treasuries in the three weeks since the Chinese yuan devaluation on Aug. 11, it might have dumped as much as $150 billion in U.S. government bonds. These are large numbers given the fact that the total net issuance of Treasuries this year will only be about $500 billion, said Bank of America Merrill Lynch in its research note. As of June 2015, China held $1.27 trillion in U.S. Treasury securities, according to capital flows data from the U.S. Treasury Department. "The presence of central banks within our markets is over-riding and it's all-encompassing and has driven the activity since 2008," said PineBridge's Vanden Assem. (Reporting by Gertrude Chavez-Dreyfuss; Additional reporting by Michael Connor, Richard Leong, and David Randall; Editing by David Gaffen and John Pickering)