US yields rose despite subdued inflation as investors looked beyond the Federal Reserve

NEW YORK (Reuters) – The recent rise in U.S. bond yields combined with a weak inflation outlook is a signal to some bond fund managers that economic resilience and rising bond supply now play a bigger role than skepticism about the Federal Reserve. Spare.

Record 10-year nominal yields on Tuesday hit near 16-year highs amid concerns about US Federal Reserve Chairman Jerome Powell sending a hawkish message about keeping interest rates high at the annual Jackson Hole Symposium on Friday.

Bond yields, which move inversely to prices, tend to rise in an inflationary environment because inflation erodes the value of future bond payments.

But while higher moves in bond yields in the past few months have often been driven by investors pricing higher interest rates as the Fed sought to tame surging inflation, expectations about the pace of price rises have cooled in recent weeks.

“The narrative has changed a lot over the past few months,” said Calvin Norris, portfolio manager and US interest rate strategist at Aegon Asset Management.

Investors are seeing evidence that a new set of drivers are taking hold, including the Bank of Japan allowing yields to rise, which could reduce foreign investors’ appetite for Treasuries, and increasing the supply of US government bonds, with investors demanding more in order to hold more debt.

While the timing and scale of the central bank’s monetary tightening has preoccupied bond investors for more than a year, the market may have reached an “inflection point in terms of a key driver of sentiment,” BMO Capital Markets analysts said in a recent note. week.

“The source of uncertainty is moving away from (the Federal Reserve) and moving towards derivatives of monetary policy in the economic fallout of interest rates at their highest level since 2001,” they said. “The issues of long-term growth, term premium, and issuance account for an increasing share of price action.”

Soft landing

Annual growth in consumer prices has slowed from a peak of more than 9% in June 2022 to around 3%, much closer to the Fed’s target of 2% after policymakers delivered 525 basis points of rate hikes starting in March 2022.

Meanwhile, inflation expectations over the next decade, as measured by the inflation-protected securities market, have remained relatively stable in recent months. The 10-year inflation rate, at 2.35%, was nearly 5 basis points higher since the beginning of the year, while the 10-year nominal yield rose by 50 basis points.

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“We expect a soft landing, which means we see things going in favor of the Fed, with lower inflation and less recession,” said John Madzier, senior portfolio manager and chair of the Fed. US Treasury bonds and tips at Vanguard Fixed Income Group.

Long-term Treasury yields take into account factors such as inflation expectations and term insurance premiums, or what investors demand to compensate for the risks of holding long-term securities.

“A lot of the movement we’re seeing right now has to do with long-term structural issues, whether it’s around growth or around term premiums,” said Anthony Woodside, head of US fixed income strategy at LGIM America.

Yields are also a reflection of expectations around the so-called neutral rate – the level at which interest rates are neither stimulating nor constraining to the economy. A recent string of strong economic data despite rising interest rates has reinforced investors’ beliefs that interest rates will remain higher for longer, even if inflation is tamed.

“The fact that growth has been so strong and remains so resilient, even at these bound rates, means that the neutral rate is likely to be higher now,” Madzier said.

While these longer-term factors have become more prominent recently, the Fed’s more immediate monetary policy action could return to the driver’s seat in the event of an acceleration of inflation or a sharp deterioration in the economy.

Money markets expect the Fed to maintain interest rates in the current range of 5.25%-5.5% through the second quarter of next year before starting to ease, but many will look for clues about possible additional rate hikes from Powell’s speech in Jackson Hole on Friday. .

“I still think there is some risk that the Fed will go further, but the market is not giving that a lot of credibility right now,” said Norris of Aegon.

Reporting by Davide Barbuscia. Editing by Megan Davies and Anna Driver

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Davide Barbuscia covers macro investing and trading outside of New York, with a focus on fixed income markets. He was previously based in Dubai, where he was Reuters’ chief economic correspondent for the Gulf region, and has reported on a wide range of topics including Saudi Arabia’s efforts to diversify the economy away from oil, the financial crisis in Lebanon, as well as scoops on sovereign debt deals. for companies. and restructuring situations. Prior to joining Reuters in 2016, he worked as a journalist for Debtwire in London and had a stint in Johannesburg.

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