Bond Report: 2-year Treasury yields jump to highest in a year as Fed seen delivering ‘hawkish surprise,’ with 2 forecast interest rate hikes in 2023


U.S. government bond yields popped higher on Wednesday after the Federal Reserve held its policy interest rate unchanged as expected, but implied that it might raise interest rates earlier than it had previously expected, penciling in two interest rate increases in 2023.

The Fed also reiterated the view held by a number of policy makers that the current surge in inflation is transitory.

How Treasury yields are performing
  • The 10-year Treasury note yield

    was at 1.559%, compared with 1.498% at 3 p.m. Eastern Time on Tuesday. The note hit its highest level since June 7.
  • The 30-year Treasury bond

    was yielding 2.211%, versus 2.199% a day ago. Also its highest rate in about 9 days.
  • The 2-year Treasury note

    rate was at 0.203%, up 3.8 basis points and marking the third straight gain and the highest level for the short-term note since June 16, 2020, according to Dow Jones Market Data.
  • Meanwhile, the 5-year Treasury note

    rose to 0.892% from 0.784%, according to FactSet data, while the 7-year Treasury note

    climbed to 1.301%, versus 1.197% a day ago.
Drivers for fixed-income markets

The Fed’s updated June statement indicates the it still believes that inflation will be transitory. However, the rate-setting Federal Open Market Committee acknowledged that inflation would be much higher this year, raising its forecast for headline personal-consumption expenditure, its preferred inflation measure, to 3%.

During a news conference to discuss the Fed’s moves, Powell said inflation could “be higher and more persistent,” but added later that he felt that the Fed had the necessary tools to combat rising price pressures.

According to the Fed’s dot plot chart, 11 of 18 officials expect at least two rate increases in 2023. In March, only seven expected one hike.

Yields for benchmark U.S. government debt had been mostly drifting lower in the face of data that has increasingly reflected an economy recovering from the coronavirus pandemic. In fact, the 10-year Treasury, used to set rates for everything from car loans to mortgages, is down from around 1.62% at the conclusion of the Fed’s last meeting near the end of April, FactSet data show.

The Fed’s decision comes amid recent evidence of percolating inflation. The consumer-price index for May soared to a 13-year high of 5%. Elevated inflation is anathema to Treasurys because it can erode a bond’s fixed value.

Some analysts have attributed the decline in yields to growing appetite for Treasurys outside the U.S. and money-market funds hankering for richer yields in world where yields at or near 0% have become more prevalent.

In its statement the Fed said it wanted to see “substantial further progress” before slowing down the purchases — the first step of pulling back all the support for the economy. However, Powell said that policy makers had the ‘talking about talking about’ tapering discussion but still think there is work to do to reach the Fed goals.

Some have made the case that the $120 billion a month in asset purchases are less needed and the $40 billion of purchases in mortgage-backed securities comes at a time when the housing market appears to be overheating.

Powell said the timing of any tapering of bond purchases will depend on the coming data, which puts weight on future inflation measures and employment gauges.

Meanwhile, the Fed made a technical adjustment to its policy tools, lifting its interest rate on excess reserves, or IOER, by five basis points to 0.15%, as a number of strategists had expected, amid a crush of money managers and banks looking to park funds with the Fed.

What strategists and traders say

“The economy has boomed over the past 12 months but is poised to slow in the second half of this year. Demand has been pulled forward and is expected to retrace its outsized gains. GDP growth is destined to slow sharply. This will be an important consideration for Fed policymakers who are debating the need to mitigate today’s extraordinary monetary accommodation,” wrote Joe LaVorgna, Natixis managing director and chief economist of the Americas, in a Wednesday note. 

“The Fed offered a modest hawkish surprise via the updated projection of policy rates in 2023 – adding 50 bp.,” wrote BMO Capital Markets strategists Ian Lyngen and Ben Jeffery, in a research note.

“Nonetheless, this doesn’t detract from the price action itself which saw 5-year yields move to 91 bp on the kneejerk and 10s flirt with 1.59%,” the BMO strategists wrote.

“We’re tempted to conclude that the endorsement of the market’s pricing of liftoff was the Fed was simply updating their projections to reflect the reality of the stronger inflationary bounce – bringing into question the appropriateness of the ‘transitory’ characterization. Particularly if it warrants a more meaningful pace of rate increases when the time arrives,” they said.

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