Treasury bulls brace for reckoning with forces driving inflation

BOND bulls have regained the upper hand in the Treasury market, on course for its first monthly gain since November. They’re about to find out if they can keep it.

The Federal Reserve’s first half-point interest-rate hike in 2 decades this month - and expectations for more - have tanked the stock market and inflation expectations. Goldman Sachs senior chairman Lloyd Blankfein and strategists from Citigroup have raised the risk of a recession - a prospect that helped drive Treasuries to the strongest levels since mid-April.

Yet May employment data in the coming week could highlight labour market strength that’s motivating the Fed to prevent a wage-price spiral. At the same time, signs of worsening liquidity undermine confidence the Treasury market can process a rapid shift in sentiment in an orderly way.

“We are at the point in the cycle where the investor focus vacillates between the inflation and growth stories,” said Jonathan Duensing, head of fixed income at Amundi Asset Management US. “We need clarity on the path of inflation and growth and what ultimately the Fed needs to do to accomplish its inflation goals.”

Treasuries are getting a respite from what had been an unrelenting bear market. Benchmark 10-year yields extended their retreat from May’s peak of 3.2 per cent, the highest in more than 3 years. The Bloomberg Treasury Index pared its year-to-date decline to 7.8 per cent from 9.6 per cent through May 6. 

The rebound was sparked by signs consumers are buckling under surging energy and food costs, while higher interest rates are cooling housing. A 17 per cent slump in new home sales on May 24 helped drive the Treasury market’s biggest 1-day gain since February.

It’s an example of the “pain” that Fed chair Jerome Powell alluded to earlier this month, in discussing the need to restore price stability. While traders still expect another half-point rate increase in June, they’re beginning to entertain a smaller hike in July. 

Rates markets are also starting to price in a pause by the Fed in September - an outcome Bank of America strategists said was likely to gain traction in the market, even if it doesn’t come to pass.

Short-dated tenors most sensitive to changing Fed policy expectations led the Treasury rally this week. Five-year yields shed 8.2 basis points, while 30-year yields ended the week lower by 2.2 basis points. The gap between the 2, which briefly turned negative last month, exceeded 30 basis points for the first time since mid-March.

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The recent steepening in the yield curve is a reflection of “growth concerns”, said Leo Grohowski, chief investment officer for BNY Mellon Wealth Management. “The next 2 rate hikes are pretty much baked in, and then the pace should moderate as the economy and inflation both cool.” 

May employment data due Jun 3 is anticipated to show average hourly earnings still exceeding 5 per cent at an annual pace, while unemployment is expected to drop to a 2-year low of 3.5 per cent. Readings this month for ISM (Institute for Supply Management) manufacturing and services gauges are also set to be released. 

The Treasury market has shown signs that it’s less able to cope with sentiment shifts since the Fed stopped buying securities in March. The Bloomberg US Government Securities Liquidity Index - a gauge of deviations in yields from a fair-value model - this week reached the highest since March 2020, when the pandemic’s onset sparked a flight to cash that spurred the Fed to inject liquidity into the market. 

Several recent Treasury auctions - including Thursday’s 7-year note sale - have produced record low awards to primary dealers. JPMorgan Chase strategists say that’s a function of poor secondary-market liquidity incentivising investors to participate in auctions.

Minutes of the Fed’s May meeting, released Wednesday (May 25), revealed concern that tightening “could interact with vulnerabilities related to the liquidity of markets for Treasury securities”. In addition to raising rates, the Fed plans to shrink its portfolio of Treasuries by not replacing a portion of those that mature beginning Jun 1. BLOOMBERG