The Business Times

US bond market losses just beginning as Fed sets path to 4% yields

Published Thu, Jun 16, 2022 · 04:48 PM

IT IS too soon to call an end to America’s worst bond market collapse in at least half a century.

Treasuries resumed losses on Thursday (Jun 16) with yields surging around 10 basis points, a day after Federal Reserve chair Jerome Powell sought to soften the blow of the bank’s largest rate hike since 1994 by saying he did not expect moves of that size to become the norm.

Some signs suggest the market is yet to face its biggest challenge. Powell said it is too soon to declare victory over inflation that has surged to a 4-decade high — or even see much evidence of an economic slowdown that would contain it. And policymakers boosted expectations for where the Fed’s benchmark rate will end next year to a median of 3.8 per cent from 2.8 per cent previously. Five predicted it would exceed 4 per cent.

Such a path would almost certainly increase what are already Treasuries’ worst losses since at least the early 1970s, and spur another leg higher in rates. Two- and 10-year Treasury yields — both now around 3.3 per cent — have tended to peak in line with the Fed’s benchmark, making investors eye 4 per cent as the next milestone to test.

“It’s very clear the Fed will do whatever it takes to forcefully reduce inflation, and the terminal rate is going to be closer to 4 per cent and maybe even go higher,” said Peter Yi, director of short-duration fixed income and head of credit research at Northern Trust Asset Management. “The Fed is on a path to higher rates and even as Powell tried to downplay another 75 basis points hike next month, he said rates are still extremely low.”

Two-year yields resumed their swift increase, rising around 12 basis points to 3.31 per cent on Thursday, after a 24 basis-point drop on Wednesday had offered some respite. Similarly, large moves were seen out to 10-year securities. US stock futures also pointed lower, after the S&P 500 Index gained 1.5 per cent on Wednesday to snap a 5-day losing streak.

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The market has been extremely volatile, and many investors say 10-year yields are likely to push up to levels not seen since 2010. While Powell said the bank is “absolutely determined” to keep inflation expectations anchored to 2 per cent, a bond market proxy for the anticipated 5-year inflation rate edged up as much as 9 basis points on Wednesday to 3.03 per cent. 

“A 4 per cent yield on the 10-year note is not out of bounds,” said Charles Curry, managing director and senior portfolio manager of US fixed income at Xponance, which oversees about US$15 billion assets. “There’s going to be starts and stops in yields along the way as the Fed gets to that terminal value, which in our mind is high 3 per cent and possible 4 per cent given inflation.” 

In Europe, bonds slid once more after the Swiss National Bank unexpectedly joined the rate-hiking party with a 50 basis-point move on Thursday. It had been expected to leave borrowing costs on hold. German yields mirrored the move in Treasuries, rising around 10 basis points, while Italian debt lost early gains to follow suit.

UK bonds bucked the trend, gaining ahead of the Bank of England meeting later on Thursday, where policymakers are expected to increase rates by at least 25 basis points. That would be the fifth straight hike, with inflation forecast to hit double digits later this year.

The era of rock-bottom yields that is now abruptly ending was fuelled by years of stimulus from central banks in the wake of the 2008 financial crisis, a period when policymakers faced little pressure because inflation remained relatively tame. But the dynamics are reversing starkly worldwide, with consumer prices surging and central banks unwinding the massive bond portfolios they amassed by injecting cash into the financial system through so-called quantitative easing, or QE. The last major holdout, the Bank of Japan (BOJ), is being challenged by traders to raise its cap on bond yields. 

Any shift from the BOJ, which also meets this week, could add further headwinds to the US Treasury market, given that it has benefited from an influx of foreign buyers as yields were below zero overseas. But Japanese investors have been selling foreign bonds for much of this year, a trend that may accelerate if the BOJ allows yields to push higher.

George Goncalves, head of US macro strategy at MUFG, said an increase in the BOJ’s yield cap from 0.25 per cent to 0.5 per cent would likely spur a US 10-year “yield spike of 50 basis points”, though he said any such move could provide a buying opportunity.

Where Treasury yields will peak, however, is ultimately dependent on the direction of the economy and whether the Fed is able to bring inflation down. While yields have marched higher this year, the gap between short- and long-term rates has narrowed or inverted periodically, indicating expectations that rate hikes will slow growth or bring on a recession as soon as next year.

“You could see at a point that rates go much higher before the Fed arrests this inflation until the inversion of the curve as they ultimately cause a recession,” said Xponance’s Curry. BLOOMBERG

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