Despite higher-than-expected inflation readings for December, bond traders are intensifying their bets on a greater number of Federal Reserve interest-rate cuts starting in May. Initial surges in yields following the release of the consumer price index, which reported prices rising more than economists anticipated, were short-lived. A 30-year bond auction later in the day contributed to a sustained shift in market sentiment, prompting swap contracts to reprice to lower levels in anticipation of future Fed interest rates.
The two-year Treasury note, more responsive to Fed movements than longer maturities, experienced a decline of up to 10 basis points to 4.26%, the lowest level this year. The benchmark 10-year note saw its yield drop around 5 basis points to 3.98%.
Sinead Colton Grant, Chief Investment Officer at BNY Mellon Wealth Management, noted, “There is a broader recognition that rates are moving lower this year and, while there is still going to be volatility, getting exposure to Treasury yields at 4% is attractive.”
Despite an initial increase, the longest-dated Treasury yields remained elevated before a 30-year bond auction. Post-auction, yields in the 30-year sector and curve spreads retreated from their session highs. Notably, two-year Treasury yields surpassed 10-year yields by less than 30 basis points for the first time since early November.
Bond markets had previously witnessed a notable gap between two-year and 10-year yields last year, reflecting the conviction that Fed rate increases would negatively impact economic performance. The gap reached 110.9 basis points in March, the largest since the early 1980s.
The Federal Reserve’s 11 interest-rate hikes since March 2022 had pushed Treasury yields to multiyear highs in October. However, evidence of slowing economic growth and inflation has led the bond market to price in rate cuts beyond what Fed officials anticipate. In December, the market’s estimate for the Fed’s controlled interest rate by the end of 2024 declined by about 12 basis points to approximately 3.8%, compared to the Fed’s median forecast of 4.625%.
New York Fed President John Williams and Cleveland President Loretta Mester have both indicated that while rates are high enough to restore price stability, rate cuts may require more evidence that inflation is returning to a sustained basis of 2%.
Despite potential delays in the start of Fed rate cuts due to a “bumpier path” for inflation in the coming months, analysts such as Matthew Hornbach, Global Head of Macro Strategy at Morgan Stanley, are considering buying any rise in yields over the next few months.
Consumer prices in December rose 3.4% from a year earlier, with a 3.9% increase excluding food and energy. Jobless claims data also indicated fewer-than-expected new claims, suggesting resilience in the labor market.
Gregory Faranello, Head of US Rates Trading and Strategy for AmeriVet Securities, commented, “The inflation pathway from here is going to be bumpy, and the pathway to formerly lower rates may prove more complicated than the price action of the prior two months of 2023.”
