Treasuries Slump on Hawkish Fed Surprise as Inflation Angst Ebbs

(Bloomberg) -- The Federal Reserve appears to have convinced the world’s biggest bond market that it’s ready to act to keep the U.S. economy from overheating if it needs to.

Treasury yields surged Wednesday -- led by maturities around the five-year area -- while measures of inflation expectations tumbled after policy makers surprised markets and signaled two quarter-point interest-rate hikes by the end of 2023. The central bank had previously projected rates would remain near zero through that year.

Fed Chair Jerome Powell also said officials had begun a discussion about tapering bond purchases. The pronouncements showed the central bank is gaining confidence in the economic outlook, giving a boost to bond bears. But bulls can focus on the millions still out of work in the wake of the pandemic, the lingering threat of virus variants and Powell’s insistence that the actual start of any policy normalization was still far off.

The Fed projections are “more aggressive than most market participants were expecting,” said Zachary Griffiths, a rates strategist at Wells Fargo. “That a big indicator of where the policy rate could be down the road. And also a key takeaway was that the Fed is starting to think about thinking about tapering their asset purchases.”

U.S. 10-year yields rose as much as 10 basis points on Wednesday to 1.59%, extending a rebound from a three-month low of 1.427% last week. The day’s high was still well below the 2021 peak of 1.77% reached in March.

Bond yields in Asia reset higher at the Thursday open as they followed the Treasury move. Australia’s 10-year yields jumped 10 basis points from the open, while similar-maturity yields in New Zealand climbed as much as 13 basis points.

Leading Edge

Yields in the five- to seven-year sector, which are especially sensitive to Fed policy expectations, led the increase Wednesday. The five-year rate reached the highest since April, flattening the yield curve. The prospect of Fed tightening coming closer into view sent the two-year Treasury note to a one-year high of 0.21%.

The projections of when officials envision lifting their benchmark overnight rate from near zero also boosted the dollar. Traders moved forward bets on when the Fed will start hiking to the end of 2022 from early 2023.

The Fed’s quarterly projections showed 13 of 18 officials favored at least one rate increase by the end of 2023, versus seven in March. Eleven officials saw at least two hikes by the end of that year. Seven of them saw a move as early as 2022, up from four.

“After dismissing rising inflation and inflation expectations for the past three months and focusing solely on the labor market, it feels like the FOMC just put its hands back on the wheel,” Jefferies analysts Thomas Simons and Aneta Markowska wrote in a note.

Break-even rates, a market proxy for inflation expectations, tumbled. Five-year break-evens slid about eight basis points on Wednesday to 2.41%. These rates had been surging in recent months amid the reopening from the pandemic, leaving some investors to warn that the Fed might be risking letting the economy run too hot.

The move in break-evens helped drive real yields projected over the next half decade up about 19 basis points to minus 1.54%.

If long-term inflation expectations rise significantly, the Fed will be ready to adjust policy, Powell said.

Taper Reaction

Traders now see even greater odds that the Fed will in coming months start laying out plans to taper its $120 billion in monthly bond purchases.

“Taper discussions will get more serious at the July meeting,” the Jefferies analysts wrote. “That would lay the groundwork for a firm signal from Jackson Hole,” the annual August central bank symposium held in Wyoming. This venue has been used in the past by central bankers to signal policy changes.

Powell told reporters Wednesday that while reaching policy makers’ goal of “substantial further progress” on their objectives to begin slowing its bond buying was “still a ways off, participants expect that progress will continue.”

And when the central bank is ready to signal the start of tapering, it will be very careful, Powell said. “It will be orderly, methodical and transparent.”

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