Bonds extend decline after Fed triggers one of worst days in decade

(Bloomberg) – The U.S. bond market faltered further on Tuesday, extending Monday’s declines after aggressive rate hike comments from Federal Reserve Chairman Jerome Powell drove short-term Treasury yields higher. one of their biggest daily jumps of the past decade.

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The central bank chief’s hawkish tone has led traders to rapidly raise estimates of how aggressively the Fed will tighten monetary policy this year, as rising commodity prices threaten to fuel the biggest increases. rapid consumer prices in four decades.

His comments on the possibility of a half-point hike, which doubled down on the message he gave after last week’s Fed meeting, sent yields across much of the curve at most. high since 2019. Those on two-year notes rose 5 basis points to 2.17% on Tuesday, after surging 18 basis points on Monday. The spread between 5- and 30-year yields narrowed further to the smallest since 2007, indicating that tighter policy expectations will slow the economy or even trigger a recession.

The moves compounded what is poised to be the worst quarterly losses the market has seen since at least 1973. The Bloomberg US Treasury Index has lost 5.55% since Dec. 31, topping the 5 .45% in early 1980 which stands as the largest quarterly decline since the gauge’s inception.

The selloff spread to other markets, with Australian and New Zealand benchmark bond yields jumping more than 10 basis points each and German Bund futures falling.

The severity of the losses underscores how far some investors have underestimated how far the central bank is willing to go to control inflation.

Monday’s yield move was “pretty violent,” said Tracy Chen, portfolio manager at Brandywine Global. “At the end of last week, investors, including us, thought the long term looked cheap. But our models cannot account for uncertainty about inflation due to the commodity price shock.

The tone of Powell’s remarks reinforced the view that the main monetary policy concern of the war in Ukraine is that it will worsen inflation and leave it more entrenched in the US economy. The fact that such a risk seems greater than a slowdown in growth opens the door to policy tightening at a much faster pace towards the bank’s end-2023 target of 2.8% for overnight rates.

Derivatives traders on Monday forecast rate hikes of about 7.5 quarter points in the six remaining FOMC meetings this year, effectively forecasting a hike of more than half a point. It hasn’t raised rates this sharply at its meetings since 2000.

The three-year yield at one point jumped more than 20 basis points on Monday and ended the day at 2.32%, up about 18 basis points, registering one of the strongest gains on a day at this grade over the past decade.

While price movements have been strongest in the short-term parts of the Treasury market that are typically hardest hit by monetary policy tightening, yields have also surged longer-term, including on the 10-year benchmark that serves as a touchstone for global markets. and underpins the cost of borrowing for households and businesses.

Thomas Atteberry, a bond market veteran of more than three decades who manages money at First Pacific Advisors, said Powell, adding such a degree of uncertainty to the magnitude of the Fed’s rate changes, increased the risk in fixed income markets and the potential for pain ahead.

“Over the past few cycles, the Fed has been much more methodical in its up cycles, so basically you weren’t surprised,” Atteberry said. “Powell adds this option and removes the past cycle predictability from the table, making it even more volatile and unpredictable. This has made the environment more difficult for fixed income investors.

The rise in yields has been seen around the world as central banks back off from pandemic-era stimulus to keep inflation from coming unstuck. Ten-year yields in Germany, the UK and Japan all rose this month, threatening in some cases to reduce demand for Treasuries from overseas buyers.

With Powell’s remarks indicating that the US central bank is squarely focused on the inflationary consequences of soaring commodity prices – rather than its impact on consumer demand – bond traders are speculating that the Fed could welcome a rise in long-term yields that would feed through to the economy.

It has also shifted focus to whether the Fed will use the planned reduction in its balance sheet holdings, known as quantitative tightening, in a more active way than its 2017-19 unwind to exert pressure. upward on long-term yields.

“The Fed has a big constraint now, which is inflation which is just too high now,” said Andrew Hollenhorst, chief US economist at Citigroup Inc. “The context in which this QT will happen now is that the Fed fights inflation and actually wants to do things that will tighten financial conditions, so the next round of balance sheet liquidations will most likely be anything but “watching the paint dry” – the description used during the last round of cuts.

With a few notable exceptions, the speed and magnitude of Monday’s price revision baffled bond market strategists at several major banks, who had judged that sharp increases over the past two weeks made it risky to position themselves for even higher yields. Strategists at Bank of America Corp., Barclays Plc, Citigroup and Deutsche Bank AG warned against maintaining short positions this week.

Exceptions included Goldman Sachs Group Inc., which recommended positioning on the possibility of one or more Fed rate hikes of half a point or more at some point this year and for a total of increases greater than the market expected. Similarly, Morgan Stanley said the market could “easily” fix a 3% rate for the Fed’s benchmark at the end of its cycle “in the coming days” and raise its end-of-cycle Treasury yield forecast. of year.

Powell’s hawkish tone also conveyed a rejection of recession risk signaled by the pronounced flattening this year of the yield curve between two- and 10-year bonds and in the spread between five- and 30-year yields. . He said he was focusing on the spread between short-term rates.

Read more: Powell says to watch the short-term yield curve for recession risk

“We are seeing a long-term breakout and we don’t know if it will last long until buyers step in,” said Ian Lyngen, head of US rates strategy at BMO Capital Markets. “This is a credibility event for the Fed and the more aggressive it is, the more the market has to wonder what this means concretely for the chances of a recession and the performance of risky assets.”

(Adds global bond movements to fifth paragraph.)

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