(Bloomberg) — Any hope that the Treasury market’s biggest quarterly loss had priced in a worst-case scenario for inflation and Federal Reserve rate hikes is looking increasingly illusory.
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No sooner had the first quarter ended with a 5.6% loss for U.S. government bonds, the March employment data included a bigger-than-expected drop in the unemployment rate to 3.6%, among the lowest ever recorded, and set April off to a punishing start. The yield on the policy-sensitive two-year note climbed more than 13 basis points to 2.47%, topping the 30-year rate for the first time since 2007 and pulling further away from the 10-year yield, which it had exceeded earlier in the week.
The selloff was concentrated in short-dated Treasuries, and it reflects anxiety that the course of monetary policy is going to be even more drastic than has been contemplated. The Fed hasn’t raised rates by more than a quarter percentage point since 2000. Policy makers have all but announced a half-point increase in May, and futures markets are pricing in another one in June, and beginning to favor a third in July. The implied forecast is for the policy rate to peak at around 3% in 2023 and decline in 2024 as higher rates take their economic toll.
The latest turn of events has some investors wondering if the Fed could go further. In 1994, a series of hikes included a single three-quarter-point move. While it was from a much higher base of 4.75% (compared with an upper bound of 0.50% currently), it no longer seems far-fetched.
“There’s a strong case for a policy acceleration by the Fed when you look at the employment data, and there’s a risk that they end doing more than what the market expects,” said Alan Ruskin, chief international strategist at Deutsche Bank. A rise in the funds rate beyond 3% “is absolutely plausible,” he said, which would produce a more deeply inverted yield curve as “the market will anticipate rate cuts will soon follow.”
Wall Street economists have been tripping over themselves to make predictions for the tightening cycle — which began with a quarter-point increase on March 16 — that look increasingly like the 1994-1995 series of seven hikes including three half-point moves.
Notably, Citigroup Inc. March 25 called for half-point hikes at the next four policy meetings, with a three-quarter-point move possible if inflation or long-term inflation expectations move higher. They project a peak in the range of 3.5% to 3.75%. Fed policy makers’ median forecast is 2.8%.
Minutes of the March 15-16 policy meeting — at which St. Louis Fed President James Bullard dissented in favor of a half-point rate increase are to be released on April 6. While they may shed light on the degree of support for larger moves, Fed Chair Jerome Powell and others sounded more hawkish notes in subsequent public appearances.
The outcome of the Fed’s two-day policy meeting that ends May 4 will likely turn on March inflation numbers slated to be released April 12, with jobs data coming two days after the decision.
A series of half-point hikes beginning in May would “set us up for more of a pronounced yield curve inversion,” said David Riley, chief investment strategist at BlueBay Asset Management.
While much of the Treasury curve is inverted, with two- to five-year yields higher than longer-maturity ones other than the troublesome 20-year bond, three- and five-year yields remain higher than the two-year, keeping that part of the curve positively sloped.
“It’s not a done deal that we are going to have stagflation or a recession but we are getting close,” said Jake Remley, a senior portfolio manager at Income Research + Management, which oversees about $92 billion. “That inflection point is out there somewhere, and it’s possible that at some point we may hit it soon if they keep pushing the expectations for hikes.”
What to Watch
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Economic calendar
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April 4: Factory orders
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April 5: Trade balance, ISM Services Index
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April 6: MBA mortgage applications
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April 7: Jobless claims, consumer credit
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April 8: Wholesale trade sales
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Fed calendar
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April 5: Governor Brainard, New York Fed President Williams
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April 6: Philadelphia Fed President Harker, FOMC meeting minutes
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April 7: St. Louis Fed President Bullard, Atlanta Fed President Bostic, Chicago Fed President Evans, Williams
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