Investors are rushing into longer-dated Treasurys in a bet that the Federal Reserve will act more quickly against inflation, leading to slower growth and lower interest rates in the longer term.
Yields on shorter-dated bonds rose and their prices fell Monday, reflecting higher rate expectations after the Fed’s policy meeting last week. Meanwhile, longer-dated yields dropped because higher interest rates in the near term would likely mean slower growth and lower interest rates further into the future. The shifts combined to produce what is known as the flattening of the yield curve.
“It’s flattening massively. The move has been quite brutal in the market,” said Laurent Crosnier, chief investment officer at
The Fed signaled last week that some policy makers expect two interest rate increases in 2023, and said officials had discussed an eventual tapering of bond-buying programs, although the timing remains uncertain. It also boosted inflation forecasts and said that if expectations of higher prices affect consumer and business behavior, they could act to address it. That marked a shift from a previous emphasis that inflation would be allowed to overshoot until the recovery is more certain.
The biggest moves since the Fed’s policy meeting have been in the difference between 2-year yields and 30-year yields. This has fallen by 0.25 percentage point, mostly driven by a 0.2 percentage point drop in 30-year yields to 2.023% on Monday, according to FactSet.
The gap between the 2-year and 10-year yields has also dropped significantly. Both these gaps are now back to their tightest levels since early February, before a selloff in Treasury markets that drove longer-term yields sharply higher.
A key change highlighted by Fed Chairman
came in his comments on labor markets and the high number of people who had retired during the Covid crisis, shrinking the size of the labor force. This means the economy is likely to hit full employment sooner than expected: High unemployment has been the Fed’s justification for allowing inflation to run hot in recent months.
“Employment is the key variable,” said
head of global credit strategies at fund manager Algebris.
Shortages in some labor markets and higher retirements could lead to wage inflation, which has a longer term effect on other prices than commodities, for example. But it remains hard to predict how many new jobs will be created and how many retirements will prove permanent, Mr. Gallo said. “Wage inflation is not a bad thing for society, but it might mean more volatility for financial markets.”
Bond markets in particular could see more volatility because the Fed’s tolerance for inflation is lower than people thought, according to Seamus Mac Gorain, head of global rates at J.P. Morgan Asset Management. “What this means is that the market will be very sensitive to inflation data and jobs growth from here,” he said.
Investors are having to rapidly unwind trades that were betting on the Fed letting inflation stay high without slowing bonds purchases or raising interest rates as the economy reopened. Money managers getting out of this so-called reflation trade is driving Monday’s moves, according to
an investment manager at Aberdeen Standard Investments.
“The market was sticking its fingers in its ears to all the signs that the Fed was shifting,” Mr. Athey said. “The positioning was heavily in reflation trades, a lot of positions are being cleaned out.”
Inflation expectations as measured by the Treasury market have declined in recent weeks. Five-year inflation expectations have eased from a peak of about 2.77% in mid May to less than 2.4%, while the 10-year forecast has dropped from 2.57% to less than 2.25%, according to
Betting on rising U.S. Treasury yields was seen as one of the most crowded trades, according to investors surveyed by
ahead of last week’s Fed meeting. At the same time, there had been a big fall in the share of investors expecting a steeper yield curve.
The flattening of the curve, meaning there is less difference between short-term and long-term interest rates, is seen as bad for bank profits. Stocks like
& Co. and
Bank of America Corp.
have sold off sharply this month.
There are technical factors at play too. There is growing demand for bonds from several sources coming on top of the Fed’s ongoing purchases of about $120 billion worth of Treasurys a month.
Many investors have been plowing funds back into Treasurys in recent weeks. Bond funds saw inflows last week of $16 billion, the highest in two months, according to
This added to heavy buying by U.S. banks starved of loan growth: They have bought a combined $139 billion so far in the second quarter, which means they are buying at a faster pace than during the first quarter, according to Deutsche Bank.
Foreign investors have also picked up their purchases in recent weeks.
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