The sharp investor retreat from government bonds in recent days reflects deepening gloom over the outlook for markets in the wake of Friday’s surprisingly hot inflation report.
Heading into Friday, there was widespread hope on Wall Street that bond yields had finally reached the peak of this year’s climb, having done enough to tighten financial conditions that consumer demand and inflation could gradually return to more sustainable levels. Now, many say they have little idea how high the Federal Reserve will have to raise short-term interest rates to wrest control of prices, which are currently rising at a rate several times higher than the central bank’s 2% annual target.
“There is definitely an element of capitulation,” in the bond market’s move, said Thomas Simons, senior vice president and money-market economist in the Fixed Income Group at Jefferies LLC. “There is a general acknowledgment that Friday’s data was a profound message.”
Yields on Treasurys largely reflect investors’ expectations for short-term rates over the life of a bond, and they in turn set a floor on borrowing costs across the economy. On Monday, the yield on the benchmark 10-year U.S. Treasury note settled at 3.371%, its highest close since April 2011 and up from 3.041% on Thursday.
The yield climbed further, to as high as 3.437%, in after-hours trading after The Wall Street Journal reported that the Fed could surprise the market by raising short-term rates by 0.75 percentage point at its policy meeting that ends Wednesday—an aggressive step it hasn’t taken since 1994 and an escalation from the half-a-percentage point increase it delivered at its May 3-4 meeting.
The two-year yield, more sensitive to the near-term outlook for monetary policy, settled at 3.279%, up from 2.815% Thursday, and surged as high as 3.413% in late trading after the Journal report. It has climbed 0.641 percentage point over the past seven trading sessions, the largest seven-day yield gain since 2001.
Friday’s consumer-price-index data could hardly have been more dispiriting, according to investors and analysts. Not only did headline inflation reach a four-decade high at a point when many investors had expected it to be coming down, but there were substantial price increases across the board, in everything from housing costs to children’s footwear.
Investors, therefore, couldn’t blame the report on any one category, as some had done the previous month when surging airline costs played a large role in driving up a closely watched measure of inflation that excludes volatile food and energy costs.
Delivering another blow to Treasurys, data released just an hour and a half after the CPI report showed consumers’ long-term inflation expectations rising to their highest level since 2008. That hurt the argument that anchored inflation expectations would help keep a lid on actual inflation.
“The reality is that we’re not seeing sufficient signs that things are slowing down,” said Daniela Mardarovici, co-head of multisector fixed income at Macquarie Asset Management, referring to the level of economic activity and inflation.
The result, she added, is that investors have had to increase their estimate for the so-called neutral level of interest rates that neither stimulates nor slows economic growth. That, in turn, has pushed up both short- and longer-term U.S. Treasury yields. The two-year yield surpassed the 10-year yield in after-hours trading Monday, sending what is often considered to be a warning sign about the economic outlook.
Treasury yields play a critical role in both the economy and financial markets. Their rise this year has helped push the average 30-year fixed mortgage rates above 5% for the first time in more than a decade. They have also dragged down stock prices, increasing the opportunity cost in foregoing bonds for equities and delivering a particularly heavy blow to relatively unprofitable companies valued for their longer-term earnings potential.
Bonds themselves have suffered heavy losses this year as a result of price declines, with major bond indexes on pace for their worse year on record even before Monday’s selloff.
As of Friday, the Bloomberg U.S. Aggregate bond index—largely U.S. Treasurys, highly rated corporate bonds and mortgage-backed securities—had returned minus 11% this year. Its second-worst performance over the same period was minus 2.9% in 1984, in records going back to 1976.
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Many investors and analysts still believe that the worst is likely over for bonds, pointing to slowing housing demand and plunging consumer confidence as signs that higher interest rates are already having their intended effect of cooling the economy.
Still, others warn that the poor performance of bonds could even create its own negative momentum.
“Perhaps the biggest risk for higher rates is that investors just decide to sell bonds,” said Donald Ellenberger, a senior fixed-income portfolio manager at
“If investors decide that bonds aren’t doing a very good job hedging stocks and still aren’t paying much income, we could see rates spike higher because Wall Street dealers don’t have the balance-sheet capacity or desire to warehouse bonds nobody wants.”
Write to Sam Goldfarb at [email protected]
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