(Bloomberg) — Momentum toward higher yields has stalled in the world’s biggest bond market, underscoring how rapidly traders priced in the hawkish message delivered by the Federal Reserve.
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The Treasury market selloff ended most dramatically in two-year notes, where yields peaked just below 2%, a level last seen in May 2019. Two-year yields have risen by nearly 50 basis points over the past two weeks and more than doubled from where they began the year — a much bigger move than has preceded previous Fed tightening cycles. More broadly, the subsequent pullback in yields reflects the view that the six additional rate increases the Fed has signaled for this year — combined with elevated inflation — will dent the economy.
Longer-dated yields rose less than the two-year’s and declined more from their peaks. In several cases they wound up lower than shorter-dated yields, a harbinger of recession. The eurodollar futures curve, a proxy for the direction of the Fed’s policy rate, peaks in September 2023 and declines from there, an implicit expectation that the Fed will be cutting rates by then to jump start growth.
“A lot is already priced in as far as hikes for this year and early next year,” said Yvette Klevan, portfolio manager in the global fixed-income team at Lazard Asset Management, which oversees about $240 billion in assets. “I’m not completely convinced that all of this will be realized,” with Russia’s war on Ukraine and the pandemic complicating the outlook.
The Fed’s aim is to bring inflation down without causing a recession. Its preferred inflation gauge in January was more than triple the central banks’ long-run target rate of 2%, and other measures of inflation such as the Consumer Price Index are higher still.
Chair Jerome Powell in his post-meeting news conference this week said the probability of a recession in the next year “is not particularly elevated,” judging by spending and labor market conditions, and that the economy “is very strong and well positioned to withstand tighter monetary policy.” Investors have doubts.
“We are less convinced on the underlying strength in both demand and labor markets, so remain skeptical that they follow through with their full hiking program,” said Steven Englander, global head of G-10 FX research at Standard Chartered Bank. “The Fed may use the next few meetings to front-load hikes while such moves are popular politically and with the public.”
The quarterly forecasts for their policy rate that Fed officials released this week had medians of 1.875% at year-end and 2.75% at the end of 2023, corresponding to six additional quarter-point increases this year and at least two more next year. The rate, for which the central bank sets a band, was increased to 0.25%-0.50% from 0%-0.25%.
However the dispersion of forecasts was extremely wide by historical standards, ranging from 1.375%-3.125% for this year and 2.125%-3.625% for next year. St. Louis Fed President James Bullard, who dissented from the decision in favor of a half-point increase, on Friday identified himself as the high forecaster for this year.
Shortly afterward, Fed Governor Christopher Waller said the war in Ukraine was the reason he didn’t push for a half-point increase at the meeting. Policy makers, who refrain from making public comments during the week or so leading up to their meetings, will be out in force again next week.
The Fed “can’t be too zealous and tighten the screws too tight for the economy,” said Kevin Flanagan, head of fixed income strategy at Wisdom Tree Investments. With a half-point rate hike, the Treasury curve between two- and 10-years, which narrowed to 18 basis points last week, would advance more quickly toward its first inversion since August 2019.
At the end of February, the only inverted segment of the Treasury curve was between 20- and 30-year bonds. By the end of this week, the curve was inverted between seven and 10 years and between three and five years.
The outlook is further complicated by the Fed’s plan to shrink its balance sheet by ceasing to roll over all of the maturing Treasury securities in its portfolio as they mature. The portfolio more than doubled in size to more than $8 trillion over the past two years as the Fed bought Treasuries and mortgage-backed securities to further stimulate the economy, termed quantitative easing, after cutting the policy rate as much as possible.
The plan is to stop replacing a fixed dollar amount of its maturing Treasury holdings each month. This was done from 2017 to 2019, using runoff caps that increased over time. The next iteration of quantitative tightening could being as soon as the Fed’s next policy meeting in May, “much sooner in the cycle than last time” and “faster than the last time,” Powell said after the March 15-16 meeting. Balance-sheet shrinkage “might be the equivalent of another rate increase,” he said.
“At some point in this cycle things are going be very uncomfortable when we see the Fed still tightening while the economy is already slowing,” said Alan Ruskin, chief international strategist at Deutsche Bank AG.
What to watch
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Economic calendar:
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March 21: Chicago Fed national activity index
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March 22: Richmond Fed manufacturing index
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March 23: MBA mortgage applications; new home sales
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March 24: Current account account balance; initial jobless claims; durable/capital goods; S&P Global manufacturing and services PMIs; Kansas City Fed manufacturing
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March 25: Pending home sales; University of Michigan consumer sentiment
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Fed calendar:
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March 21: Atlanta Fed President Raphael Bostic at the annual NABE economic policy conference; Fed Chair Powell at NABE conference
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March 22: New York Fed senior vice president Nathaniel Wuerffel on post-Libor world; New York Fed President John Williams; San Francisco Fed President Mary Daly; Cleveland Fed President Loretta Mester
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March 23: Powell on BIS panel; Daly at the Bloomberg Equality Summit in New York; St. Louis Fed President James Bullard
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March 24: Minneapolis Fed President Neel Kashkari; Fed Governor Christopher Waller; Chicago Fed President Charles Evans; Bostic
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March 25: Daly; Waller; Williams; Richmond Fed President Thomas Barkin
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Auction calendar:
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March 21: 13-, 26-week bills
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March 22: 52-week bills
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March 23: 2-year floating-rate notes; 20-year bond reopening
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March 24: 4-, 8-week bills; 10-year TIPS reopening
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