The U.S. Treasury market finds itself in a state of flux as shifting sentiments about the Federal Reserve’s monetary policy path leave investors scrambling to anticipate an eventual peak in interest rates.
The tumultuous journey of benchmark 10-year yields began this week with a sharp decline. This initial plunge was a result of multiple factors, including concerns over the escalating conflict in the Middle East and dovish comments from Fed officials. The latter hinted at the possibility that interest rates might not need to ascend further.
However, the yields, which move inversely to bond prices, experienced a resurgence later in the week. This resurgence followed a robust U.S. inflation report and tepid demand at the Treasury’s 30-year government bond auction. As of Thursday afternoon, the 10-year yield stood at approximately 4.7%, still some 18 basis points away from the 16-year highs touched in the previous week.
The volatility in the Treasury market has extended its ripples into the equities and other risk asset sectors. This instability is expected to persist until the market receives a clear signal regarding the Fed’s intention to decelerate its monetary tightening.
Leslie Falconio, the head of taxable fixed income strategy at UBS Global Wealth Management, noted, “The market needs to really see a slowing in the data before it believes the Fed is on a pause.” She added, “Every time the Fed pauses, yields come down, but the market is not convinced they’re quite there yet.”
The words of Fed Vice Chair Philip Jefferson and Dallas Fed President Lorie Logan on Monday further fueled the belief that the recent surge in yields might be causing financial conditions to tighten, possibly obviating the need for additional rate hikes. This bolstered the case for investors who anticipate a pause in the central bank’s rate-hiking campaign.
Mark Dowding, Chief Investment Officer at BlueBay, RBC Global Asset Management, expressed the view that “the move up in yields may have gone far enough for the time being, and we might expect a period of consolidation.”
Multiple indicators suggest that financial conditions have indeed tightened in recent months. Credit market spreads have widened, reflecting investors’ demands for higher yields on riskier assets, such as corporate bonds. Real yields, which reveal investors’ potential earnings on Treasuries when inflation is excluded, are hovering near 15-year highs. The Goldman Sachs financial conditions index recently reached its highest level in nearly a year.
A significant portion of the market seems to believe that yields are headed downward. A Reuters poll released on Wednesday revealed that strategists anticipated the U.S. 10-year yield to decrease to 4.25% by year-end.
Fed funds futures indicate that investors are pricing in a roughly 15% chance of the central bank raising rates next month, down from around 27% the previous week.
On the flip side, embracing rallies in U.S. government bonds has proven to be risky this year. The Treasury market is on track for an unprecedented third consecutive annual loss, making many investors cautious about betting on an abrupt reversal.
There has been a noticeable absence of chaotic trading or significant economic distress that would indicate financial conditions have severely hampered investors’ risk appetite to the extent that it would trigger a sustained bond rally. Edward Al-Hussainy, senior currency and rates analyst at Columbia Threadneedle, noted that despite a slight uptick in U.S. consumer prices in September, the S&P 500 remains up 14% year-to-date, with the Nasdaq Composite Index up 32%.
Al-Hussainy remarked, “Usually you would have very violent price action in risk assets, a sharp widening of credit spreads, a big ramp-up in volatility… or we have learned something about the fundamentals in the economy. But nothing like that has happened.” He further stated that he preferred to maintain exposure to the short end of the Treasury curve while avoiding long-term bonds, stating, “We feel pretty good not sticking our necks out right now; it feels premature.”
In addition to the resilient economy, several factors contributing to the recent surge in yields may continue to exert pressure on the markets, irrespective of a potential Fed pause. Among these factors are concerns that investors will seek higher returns to absorb a wave of government issuance, which could nearly double to $1.9 trillion in 2024, according to estimates from Neuberger Berman.
Jonathan Cohn, Head of U.S. Rates Desk Strategy at Nomura Securities International, pointed out, “Without something ‘breaking,’ many of the fundamental drivers of the sell-off may continue to leave long-end yields in search of a peak.”
