Treasury market rally faces reality check as Powell sets path

THE optimism that has crept into the US bond market is about to be put to the test. 

The Treasury market rallied last week, snapping a 12-week losing streak, on speculation that the Federal Reserve will signal plans to scale back its interest-rate hikes after enacting a fourth straight three-quarter-point increase on Nov 2.

The advance drove the benchmark 10-year yield back around 4 per cent, with some investors wagering that the bond-market rout is poised to end for good as the central bank’s previous moves show signs of slowing the economy. The view has gained support from Fed officials who have indicated the pace of monetary policy tightening may slow by the end of the year, potentially joining policymakers at the Bank of Canada and European Central Bank who are adjusting course or flagging the possibility of doing so.  

But investors remain deeply divided over what the Fed will do in December, with futures traders still pricing in the chance of another 0.75 percentage point rate increase. And it remains possible that neither Fed Chair Jerome Powell nor the October jobs report will clarify the outlook, which will likely hinge on whether inflation shows signs of coming down steadily from four-decade highs.  

“What will be interesting is whether Powell tries to say the front loading is over while they are looking to reach their terminal estimate,” said Priya Misra, global head of rates strategy at TD Securities, referring to where the Fed’s key rate will peak. “Powell has to say terminal risks are to the upside, but a message of the Fed downsizing will be taken by the market as being dovish.”

The bond market’s recent rebound marks the latest turn in a turbulent year, one that’s seen the deepest losses in at least half a century and the most sustained volatility since the onset of the financial crisis in 2007. Traders were burned by optimism about a false bottom earlier this year on speculation that growth was cooling, and recent options trades show the lack of conviction, with some targeting a yield drop to 3.6 per cent and others a rise back to 4.25 per cent by end of November. 

Over the next two weeks, jobs and inflation data, as well as Powell’s comments after Wednesday’s (Nov 2) meeting, will provide further insight into whether the market’s current outlook is correct. 

Among the main data releases, the ISM manufacturing index is forecast to ease to 50 in October, the dividing line between expansion and contraction, while the services gauge is only seen moderating to 55.5. The week is crowned by the monthly jobs report that’s forecast to show 200,000 new jobs created in October, marking a slight drop over the month, while the pace of annual wage growth is seen easing to 4.7 per cent from 5 per cent.

US inflation figures last week suggested a peak may be forming, with the personal consumption expenditure index steadying at an annual pace of 6.2 per cent in September. But a sense of caution is warranted as 10-year Treasury yields edged higher last Friday and European bonds sold off sharply in the wake of double digit inflation readings from Italy and Germany. 

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“The Fed will definitely go 75 in November, and I think they stay cagey about December as there are two more CPI reports before that meeting,” said Donald Ellenberger, senior portfolio manager at Federated Hermes. “They want to get off the 75 basis points treadmill, but the Fed can only step down if the inflation numbers start falling.”

The expectations that the Fed will signal plans for an eventual slowdown have been supported by growing concern that the already tight financial conditions will set off a recession. That was highlighted last week when the 10-year Treasury yield dropped the most below the 3-month since March 2020. 

That move was driven by investors increasing their holdings of longer-dated debt on expectations that growth will slow so much that the Fed will start cutting rates next year. The most recent SMRA portfolio survey showed investors returned to net long territory at 100.1 per cent for the first time since 2021, while a JPMorgan Chase & Co survey of Treasury clients was back to showing a net long holding at its highest point in two years.

“The bond market is telling you that the Fed is nearing its end game and duration is catching a bid as data points to a slowing economy next year,” said Arvind Narayanan, senior portfolio manager at Vanguard Group.  “The balance is between how much inflation falls relative to lower growth. If inflation is sticky relative to growth, the economy tips into recession and that will see Treasuries rally and being long duration will work for investors.” BLOOMBERG