Bruised Bond Bulls See Rate-Hike Pain Sowing Seeds Of 2023 Rally

(Bloomberg) -- The latest consolation for bond-market bulls is that the higher yields go over the next few months, the bigger next year’s rally will become. 

Another faster-than-expected US inflation report is galvanizing speculation that the Federal Reserve will deliver back-to-back rate hikes of 0.75 percentage points at its November and December meetings. That’s promising to extend the market’s worst losses in decades.

But the degree of the central bank’s monetary policy tightening is increasing the risk of a recession. And such a slowdown could eventually trigger a rally in longer-dated bonds as traders look for the Fed to do an about-face and start cutting rates to jump-start the economy. 

“Over a 12 month horizon, the way we look at markets, I think there is a lot of scope for rates to move lower, reflecting a slowly changing tune from both the inflation data and the Fed,” said Gene Tannuzzo, global head of fixed income at Columbia Threadneedle Investments. 

There’s no sign of such a turnaround brewing anytime soon, and the coming week lacks major data releases that would redirect speculation about the Fed’s path. The Treasury market will likely remain subject to bouts of positioning shifts and volatility, with recent swings also spurred in part by turmoil in the UK.

On the heels of still-strong September employment data, the acceleration of a key consumer-price gauge to a 40-year high is leaving the Fed with more to do to achieve its price-stability mandate. 

The prospect of a persistently hawkish Fed was also laid out by the minutes from the US central bank’s September policy meeting, when many officials were more concerned about tightening policy too little than too much. 

This week, the policy-sensitive two-year Treasury yield touched 4.53%, its highest since 2007, extending this year’s relentless climb from around 0.7% at the end of December. Ten-year yields rose for the 11th straight week but remain about 50 basis points below those on the two-year notes, a so-called yield-curve inversion that signals expectation the economy will slow. Fed funds futures are pricing in that the rate will peak near 5% in March.

“The Fed is committed to raising rates until they see inflation coming down,” said Monica Erickson, head of investment-grade corporates at DoubleLine Capital. “And the curve, with 2s10s so inverted, is telling you that the Fed is going to push us, if not into a major slowdown, then a full-blown recession. With that you could get lower rates on the long end -- and still higher rates on the short end.”

Economists at Barclays on Thursday upgraded their policy outlook to project three-quarter-point hikes for both November and December, followed by a half-point increase in February. While that boosted the bank’s forecast for the peak rate to a range of 5%-5.25% in February, up from their prior call of 4.5%-4.75%, it is projecting that the Fed will start cutting rates next year.

“With the FOMC’s backward-looking reaction function intensifying overtightening risks, we now expect the Federal Open Market Committee to cut the funds rate by 75 basis points in the final three meetings of 2023,” Barclays economist Jonathan Millar wrote in a note with his colleagues. “This would place the target range for the funds rate at 4.25-4.50% at end-2023.”

Yellen Worries Over Loss of ‘Adequate Liquidity’ in Treasuries

For bond investors, any near-term relief from the worst bear market since at least the early 1970s looks doubtful until labor and inflation data weaken sufficiently to enable the Fed to moderate the pace of its rate hikes and signal plans to pause. That means front-end yields are likely to keep heading higher, testing the mettle of investors who gravitated there expecting that the Fed’s tightening was drawing toward a close.

“A lot of clients are in the front end,” and in the wake of the CPI report, “we see the Fed getting to 5% and then pausing to see the effect of their tightening,” said Mona Mahajan, senior investment strategist at Edward Jones.

In the upcoming week, traders will also contend with an auction of 20-year bonds, a benchmark that has lacked support and consistently traded above the 30-year in yield over the past year. 

What to Watch

• Economic calendar
  • Oct. 17: Empire manufacturing
  • Oct. 18: Industrial production; capacity utilization; NAHB housing market index
  • Oct. 19: MBA mortgage applications; housing starts; Fed beige book
  • Oct. 20: Philadelphia Fed survey; jobless claims; existing home sales; Conference Board leading index
• Fed Calendar:
  • Oct. 18: Minneapolis Fed President Neel Kashkari; Fed Vice Chair Lael Brainard
  • Oct. 19: Chicago Fed President Charles Evans; St. Louis Fed President James Bullard; Kashkari
• Auction calendar:
  • Oct. 17: 13-, 26-week bills
  • Oct. 19: 20-year bond
  • Oct. 20: 5-year TIPS; 4-, 8-week bills

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