NEW YORK (Reuters) – As inflation worries grow in the U.S., some investors are preparing for the 10-year U.S. Treasury yield to break through the 16-year high of 5% hit last October.
Bond yields, which move inversely to prices, have risen in recent weeks as signs of persistent inflation undermine expectations about how much the Federal Reserve can cut interest rates without further boosting consumer prices. The yield on the benchmark 10-year bond has risen 80 basis points this year and was last at 4.70%, a five-month high.
Many investors believe that further weakness is ahead for bonds. Global fund managers’ fixed income allocations fell to their lowest level since 2003 in the latest BofA Global Research survey. According to BofA data, bearish Treasury positioning among some classes of hedge funds is at its highest level of the year, even as other asset managers have increased their bullish bets.
“It all boils down to one word: inflation. If the market doesn’t see any signs that inflation is contained, there is no reason why yields won’t continue to rise,” said Don Ellenberger, senior portfolio manager at Federated Hermes. He has reduced his portfolio’s interest rate sensitivity amid concerns that stubborn inflation and labor market strength could push yields as high as 5.25%.
Further evidence that inflation is accelerating again came on Thursday. Data showed that the personal consumption expenditure (PCE) price index excluding food and energy rose far more than expected in the first quarter. Futures markets showed that investors now expect the Fed to cut interest rates by just 35 basis points this year, compared to the more than 150 points priced in at the start of 2024.
Another hot inflation reading on Friday when March PCE data is released could further close the window for rate cut expectations this year. Further insights into the economy could come at the conclusion of the Federal Reserve’s monetary policy meeting on May 1.
‘high water mark’
The level of Treasury yields is closely watched by market participants as higher yields lead to higher borrowing costs for consumers and businesses and can tighten financial conditions in the economy.
A sharp rise in yields in the second half of 2023 triggered a selloff in the S&P 500, although stocks recovered as yields reversed. This year’s stock rally has stalled in recent weeks as yields have risen and the S&P 500 has pared its year-to-date gains from more than 10% to around 6%.
Some investors have taken advantage of bond weakness to add to their bond holdings, confident that yields are unlikely to rise further unless the Fed announces it will raise its federal funds rate again from the current range wants to raise 5.25% to 5.50%. However, others were skeptical that inflation would cool down soon.
“Inflation is not going down the way the Fed thought,” said Arthur Laffer, president of Laffer Tengler Investments, who is bearish on longer-dated Treasury bonds and thinks yields could rise as high as 6%. “Right now you’re not getting paid to take risks in the bond market.”
Michael Purves, chief executive of Tallbacken Capital Advisors, wrote that it was “not inconceivable” that the 10-year Treasury yield could reach its 2007 peak of 5.22% if higher prices for oil and other commodities continue to drive down inflation drive up.
The price of Brent crude has risen about 17% since the start of the year, even after declining last week on fears of a major conflict in the Middle East.
Budget concerns are another factor that could push yields higher. The rating agency Fitch downgraded the US’s credit rating last year due, among other things, to concerns about rising debt levels. Many investors are anticipating an increase in term premiums – or the compensation required for holding long-term debt.
“Fiscal conditions in the U.S. are starting to play a role, and if the market starts to become more concerned, that could put tremendous pressure on returns and a decline in stock valuations in a very short period of time,” said Bryant VanCronkhite, a senior executive Portfolio manager at Allspring Global Investments who expects 10-year Treasury yields to rise above 5%.
Still, there are reasons to believe a return to 5% yield would be a “high water mark” for investors, said Alex Christensen, portfolio manager at Columbia Threadneedle Investments, who is overweight two-year Treasury bonds.
The market narrative that has prevailed since the so-called Fed pivot in December “was very one-sided and left little room for changes in the inflation trend,” Christensen said.
He believes the Fed is unlikely to move toward raising interest rates.
“We believe the overall inflation trend is stable to declining,” he said.
(Reporting by David Randall; Editing by Ira Iosebashvili and Paul Simao)