With escalating concerns over inflation in the United States, investors are bracing themselves for the possibility of the 10-year U.S. Treasury yield surpassing the 16-year high of 5% reached last October. Bond yields, which exhibit an inverse relationship with prices, have surged in recent weeks amidst indications of persistent inflation, diminishing expectations of significant interest rate cuts by the Federal Reserve without exacerbating consumer price pressures. Currently standing at 4.70%, the yield on the benchmark 10-year note has climbed by 80 basis points since the beginning of the year, marking a five-month peak.
Many investors are hedging against potential bond weakness, as evidenced by global fund managers’ reduced fixed income allocations, reaching their lowest levels since 2003 according to the latest BofA Global Research survey. Additionally, BofA data highlights heightened bearish Treasury positioning among certain hedge fund categories, contrasting with increased bullish bets among other asset managers.
The primary driver behind these market dynamics, according to Don Ellenberger, senior portfolio manager at Federated Hermes, is inflation. Ellenberger underscores that without signs of contained inflation, there’s a strong likelihood of further upward pressure on yields. He has adjusted his portfolio’s interest rate sensitivity accordingly, expressing caution that persistent inflation and robust labor market conditions could propel yields to as high as 5.25%.
Recent data indicating a significant uptick in the personal consumption expenditures (PCE) price index, excluding food and energy, reinforces concerns about resurgent inflation. Consequently, futures markets now reflect diminished expectations for Fed rate cuts this year, contrasting sharply with initial projections at the outset of 2024.
The forthcoming release of PCE data for March, scheduled for Friday, could provide additional clarity on inflation trends, potentially influencing market sentiment following the U.S. central bank’s monetary policy meeting on May 1.
Given the close scrutiny of Treasury yields by market participants, elevated levels could translate into heightened borrowing costs for consumers and corporations, thereby tightening financial conditions within the economy.
The surge in yields witnessed towards the latter part of 2023 triggered a sell-off in the S&P 500, although equities rebounded when yields retreated. However, the recent ascent in yields has tempered the rally in stocks, with the S&P 500’s year-to-date gains halved to approximately 6%.
Amidst the bond market weakness, some investors have seized the opportunity to bolster their fixed income holdings, confident that yields are unlikely to surge further unless the Fed signals intentions to raise its benchmark overnight interest rate from the current range of 5.25%-5.50%. However, skepticism persists regarding the prospects of cooling inflation in the near term.
Arthur Laffer, president of Laffer Tengler Investments, expresses bearish sentiment towards longer-dated Treasuries, envisaging yields potentially reaching as high as 6%. Similarly, Michael Purves, head of Tallbacken Capital Advisors, contends that the 10-year Treasury yield could approach its 2007 high of 5.22%, should inflationary pressures persist.
Factors such as rising oil prices and fiscal concerns contribute to the upward pressure on yields. The recent downgrade of the U.S. credit rating by Fitch, attributed in part to escalating debt levels, further exacerbates apprehensions among investors.
Nonetheless, some analysts believe that a return to 5% yields may represent a peak for investors. Alex Christensen, a portfolio manager at Columbia Threadneedle Investments, maintains an overweight position in two-year Treasuries, expressing confidence in the stability or potential decrease of the general inflationary trend. Christensen anticipates that the Fed is unlikely to pivot towards rate hikes in the foreseeable future.
