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Treasury Market’s Main Battleground Has Shifted Into Next Year

(Bloomberg) — The principal fault lines in the US bond market have re-located. An emerging consensus that the Federal Reserve will finish raising interest rates this year has investors grappling with what happens after that.

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To be sure, there’s ample uncertainty about how high the Fed’s policy rate will need to rise in order to restore price stability in the economy, and how it will get there. Just this week, a skirmish broke out over whether the July meeting will deliver another three-quarter-point increase or the first full-point one since the 1980s, after June inflation increased more than expected.

However the main battleground has shifted to how long the overnight benchmark might remain at its peak level and how much, if at all, it will decline next year — questions that depend on how the economy copes with a policy rate that’s expected to reach 3.5%, from its current range of 1.50%-1.75%. This week’s decline in 10-year yields to levels more than 20 basis points lower than two-year yields signal pessimism on that front.

“Sure, we can reach a recession, but as investors, we have to think about what it would look like and what’s on the other side of it,” said Anthony Crescenzi, a portfolio manager at Pacific Investment Management Co.. His outlook is for a mild recession in which the Fed keeps the policy rate steady at its peak level rather than bringing it quickly back down, and that investors will be hesitant to pile back into bonds after this year’s steep losses.

“The memory of what happened in the bond market this year will last for a generation,” Crescenzi said on Bloomberg Television. Barring a much deeper economic recession than most people foresee, “investors won’t be so quick to drive yields down that fast,” he said.

The view that the policy rate will peak around the end of this year or early next year is apparent in swap contracts tied to Fed meeting dates. The December 2022 and February 2023 contracts carry the highest rates, just above 3.5%. Late 2023 rates are around 3%, reflecting the consensus view that rate cuts will follow the hikes, which began in March this year as the main US inflation rate approached 8%.

This week’s tussle over the July meeting was temporarily resolved in favor of another three-quarter-point hike rather than a larger one, as two Fed policy makers backed that choice before a self-imposed pre-meeting quiet period. But at least three banks are forecasting a full-point move, and swap rates assign a one-in-six change of that outcome.

While the June rate for the consumer price index reported this week was 9.1% — a new generational high — there are indications that tighter policy is beginning to bite. Led by oil, a broad index of commodity prices returned to levels that prevailed before Russia’s invasion of Ukraine in February led to steep gains.

The US national average price of gasoline has declined every day since mid-June and is down 8.8% over the period. With that, the real yield on inflation-protected Treasuries maturing in two years rose back above 0% for the first time since May 2020. Fed Chair Jerome Powell at the news conference after the June meeting said that positive short-term real yields were an indicator of a near-neutral policy rate, neither stimulative nor restrictive.

Additional Fed rate increases are likely to further close the gap between two-year real rates still under 0.2% and 10-year real rates around 0.6%.

“A positive real two-year yield is moving in the right direction,” said Steven Blitz, chief US economist at TS Lombard. But he says it needs to exceed the 10-year real yield in order to tighten financial conditions enough to throttle inflation, and that the funds rate will need to reach at least 4% to make that happen.

Ten-year real yields have declined by about 30 basis points from their mid-June peak of 0.88%. An auction on July 20 of new 10-year Treasury Inflation-Protected Securities will provide information about the extent to which demand has been dented by cooling commodity prices.

Next week’s other significant auction, a 20-year bond reopening on July 19, is a potential stumbling block for the broader market. Reintroduced in 2020, the tenor is still struggling to gain acceptance, evidenced by its yield that’s been higher than the 30-year bond’s since October.

What to Watch

  • Economic calendar:

    • July 18: NAHB housing market index, TIC flows

    • July 19: Housing starts

    • July 20: MBA mortgage applications, existing home sales

    • July 21: Philadelphia Fed business outlook, weekly jobless claims

    • July 22: S&P Global US manufacturing and services PMIs

  • Central bank calendar:

  • Auction calendar:

    • July 18: 13- and 26-week bills

    • July 20: 20-year bonds

    • July 21: 10-year Treasury inflation protected securities, 4- and 8-week bills

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