Bond yields are sending a new signal about Fed rate hikes
After months of sounding the alarm on potential Federal Reserve interest-rate increases, the script suddenly flipped in the $30 trillion U.S. Treasury market.
This week’s pullback in the policy-sensitive 2-year Treasury yield BX:TMUBMUSD02Y, as the below chart shows, signals an easing of that concern. Cooler inflation data might now keep the Fed from increasing interest rates.
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This comes despite resumed U.S. military strikes against Iran and global Brent prices BRN00 climbing back above $86 a barrel. They eclipsed $110 earlier in the conflict.
“That’s the spring war premium unwinding,” Vincent Ahn, president and portfolio manager at SLW Investments, said on Friday, referring to the move lower in 2-year yields. “That’s the whole move.”
The Fed “is handcuffed” on the supply side of inflation, he said, but you “can’t hike your way into producing more oil for the global economy.”
The 2-year yield was at 4.17% on Friday, after touching a high earlier in the week of about 4.29%, according to FactSet. It’s above the Fed’s 3.75% upper limit of its policy range, suggesting investors are still prepared for the possibility of hikes — only less so.
What helped the yield retreat was new inflation readings that moved the annual inflation rate closer to the Fed’s 2% target. Specifically, lower gas prices helped the consumer-price index fall in June to a 3.5% yearly rate from 4.2% a month before.
“The market trades the trend in inflation, not the price of a single barrel, and the trend broke lower,” Ahn said.
Brent prices gained about 14% this week. That raises the prospect of gas-price relief being short-lived.
See: Brace for $4 gas again: How U.S.-Iran tensions are threatening to end the price break at the pump.
Still, the pattern of Treasury yields and oil moving mostly in concert during earlier stages of the conflict appears to have broken down. The relationship started changing in June. It followed new Fed Chairman Kevin Warsh’s first press briefing at the helm of the central bank, where he vowed to get inflation down to 2%.
There was also June’s U.S.-Iran ceasefire agreement that briefly allowed more Persian Gulf oil to flow through the Strait of Hormuz. Traffic has since fallen to a three-week low, according to MarineTraffic.
Ahn called the June inflation data a “one month grace period, not a get out of a jail card.” Should the new chapter of the Iran conflict drag on, the inflation damage becomes harder to contain.
“It’s going to be a bit of déjà vu,” said Luis Alvarado, co-head of global fixed-income strategy at the Wells Fargo Investment Institute, on Friday. “Many factors are jumping around, back and forth.”
Still, current yields better reflect the thinking that the Fed will stay on pause, while retaining the optionality to implement changes, Alvarado said. That’s also Well’s view.
Warsh reiterated a message of “no tolerance” for persistent and stubbornly high inflation during testimony this week to Congress.
Big moves weren’t only happening in short-term Treasury yields this week. The benchmark 10-year yield also pulled back to 4.54% on Friday from a 4.64% high earlier in the week, according to FactSet.
“That’s a reflection of what’s happening in the stock market,” Alvarado at Wells said. “The whole dynamic of hyperscalers, chip makers and the AI related story.”
The benchmark PHLX Semiconductor Index SOX was set to enter a bear market on Friday, defined by a drop of at least 20% from a prior peak. The S&P 500 SPX, Dow Jones Industrial Average DJIA and Nasdaq composite COMP were set for weekly declines.
Earlier in the week, the focus was on robust bank earnings. “The tune changed very quickly,” Alvarado said.