Treasury yields post the biggest one-day drop in months as bond investors shrug off data showing U.S. inflation at 30-year high

What yields are doing

• The 10-year Treasury note yields TMUBMUSD10Y, 1.463% 1.464%, down 6.4 basis points compared with 1.528% at 3 p.m. Eastern Time on Thursday, according to Dow Jones Market Data. It was the largest one-day decline in the rate since Aug. 13, based on 3 p.m. levels.
• The 2-year Treasury note TMUBMUSD02Y, 0.269% was yielding 0.264%, down 2.5 basis points from 0.289% a day ago. It was the biggest daily drop since July 14.
• The 30-year Treasury bond rate TMUBMUSD30Y, 2.031% was at 2.037%, lower by 5.5 basis points from 2.092% on Thursday. It was the largest one-day fall since Sept. 20.

What’s driving the market?

Yields for government debt fell during the session as traders brushed brushed off Friday’s update on the personal consumption expenditure price index.

Read: U.S. inflation rises again in August and stays at 30-year high

The personal consumption expenditure index rate of inflation in the 12 months ended in August edged up to 4.3% from 4.2% — the highest level since 1991, when George H.W. Bush was president — with all signs pointing to rising prices leaking into next year. The yearly pace of core PCE inflation, which strips out volatile food and energy prices, was unchanged at 3.6%, but also at a 30-year peak.

The report — coupled with a global energy shortage  unfolding across the U.K., Europe and China — is heightening investors’ concerns that the U.S. may already be embarking on a stagflation-like path that causes higher inflation to linger for far longer than previously thought.

Read: ‘Stagflation is here,’ following months of rising prices, BofA analysts say

Until very recently, Federal Reserve officials had insisted inflation would start to fall back toward pre-pandemic levels of 2% or less by year-end. But over the past week, senior central bank leaders acknowledged that inflation could remain high well into 2022 because of ongoing shortages of crucial business supplies and even labor.

A top executive from the Institute for Supply Management addressed the supply-chain breakdowns on Friday, by saying the bottlenecks fueling higher U.S. prices could last into next spring.

Higher inflation chips away at a bonds fixed value and some fear that the Fed may have to ratchet up the pace of interest-rate increases, even if economic growth slows, once it concludes the tapering of monthly asset purchases.

Ordinarily, bond investors would be selling off Treasuries in the face of higher inflation, causing yields to rise as inflation premium gets embedded into market-based rates. But instead, investors were buying government bonds on Friday, suggesting they still think inflation will eventually moderate at some point and that Friday’s raft of data hadn’t shifted their views.

Friday’s other economic reports showed that U.S. consumer incomes increased 0.2% in August and the Institute for Supply Management’s manufacturing PMI rose to 61.1% in September from 59.9% in the prior month. The final reading of IHS Markit’s manufacturing purchasing managers index for September came in at 60.7 versus a 60.5 initial estimate.

On Thursday, Federal Reserve Chairman Jerome Powell, appearing at a House Financial Services Committee hearing alongside Treasury Secretary Janet Yellen, said that the pressures pushing inflation higher could last until next summer, but he isn’t clear about precisely when pricing pressures might reverse.

“We expect that those will abate, that they’ll lessen, and over time inflation will come back down,” Powell said. “Exactly when that will happen is not possible to say.” 

Until the past two trading sessions, yields for government debt had mostly been on a march higher since the conclusion of the central bank’s late-September meeting. That’s when officials indicated they could start reducing monthly purchases of $120 billion in Treasurys and mortgage-backed securities before the end of 2021, with the intent of completing the process by the middle of next year. New Fed projections also showed that half of 18 officials expect to raise interest rates by the end of 2022, up from seven in June.

Beyond the outlook for Fed policy and inflation, fixed-income investors have also been watching Washington politics. Speaker Nancy Pelosi called off a planned vote Thursday in the U.S. House of Representatives on a $1 trillion bipartisan infrastructure bill, with Democratic lawmakers remaining unable to agree on their other spending proposals.

In addition to wrestling with big plans for public works and social programs, Democratic-run Washington dealt with a deadline to fund the government to avoid a partial shutdown, but deferred action on the federal debt limit. On Thursday, President Joe Biden signed into law a short-term spending bill to keep the U.S. federal government running through Dec. 3, acting with just hours remaining before a partial shutdown was due.

What analysts say

• “This is the first week that markets realized that global growth could be weak and inflation more persistent,” Athanasios Vamvakidis, BofA’s global head of G10 FX strategy, said via phone from London. “Energy-price increases were a wake-up call for markets, and the scenario that’s now more likely to develop is one in which we get higher inflation and weaker output.”
• “Treasuries shrug” in response to early Friday’s data, BMO Capital Markets strategist Ian Lyngen wrote in a note. “Overall, an uninspired round of data that does little to shift the macro landscape.”
• “Markets appear increasingly jittery as the realization of a higher sustained level of inflation eventually resulting in a higher level of rates appears to be finally sinking in,” said Lindsey Piegza, chief economist of Stifel Financial. “While the Fed has assured market participants the taper process is only the first step towards a removal of accommodation and it will be slow and controlled, investors are increasingly focused on step two: the inevitable backup in rates.”