No escape from biggest bond loss in decades as Fed continues to hike

(Bloomberg) — Investors who may have been expecting the world’s largest bond market to bounce back soon from its biggest losses in decades look set for disappointment.

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Friday’s U.S. jobs report illustrated the economy’s momentum in the face of the Federal Reserve’s escalating efforts to cool it, with businesses rapidly adding jobs, wages rising and more Americans entering the workforce. While Treasury yields edged lower as the numbers showed a slight easing of wage pressures and a rise in unemployment, the overall picture fueled speculation that the Fed is poised to keep raising interest rates — and keep them there — until the surge in inflation subsides .

Swaps traders see a slightly better chance that the central bank will continue to raise its benchmark interest rate by three-quarters of a percentage point on September 21 and tighten policy until it reaches around 3.8%. That suggests more downside potential for bond prices, as 10-year Treasury yields have reached or exceeded the Fed’s peak rate during previous cycles of monetary tightening. That yield is now around 3.19%.

Inflation and the Fed’s hawkish behavior “have bitten the markets,” said Kerry Debs, a certified financial planner at Main Street Financial Solutions. “And inflation is not going to go away in a few months. This reality bites.”

The U.S. bond market has lost more than 10 percent in 2022, putting it on pace for its biggest annual loss and first consecutive annual declines since at least the early 1970s, according to a Bloomberg index. A recovery that began in mid-June, fueled by speculation that the recession would lead to interest rate cuts next year, was largely erased as Fed Chairman Jerome Powell emphasized that he was focused entirely on reducing inflation. The two-year Treasury yield on Thursday hit 3.55%, the highest level since 2007.

At the same time, short-term real yields – or those adjusted for expected inflation – rose, signaling a significant tightening of financial conditions.

Rick Reeder, chief investment officer of global fixed income at BlackRock Inc., the world’s largest asset manager, is among those who think long-term yields could rise further. He said in an interview with Bloomberg TV on Friday that he expects a 75 basis point increase in the Fed’s interest rate this month, which would be the third consecutive move of that size.

Friday’s jobs report, showing a slowdown in wage growth, allowed markets to “heave a sigh of relief,” according to Rieder. He said his firm has been buying some short-term fixed-income securities to take advantage of the big rise in yields, but he thinks those in longer-maturity bonds have more room to grow.

“I see rates going up in the long term,” he said. “I think we’re in a range. I think we’re at the upper end of the range. But I think it’s pretty hard to say we’ve seen the peaks at the moment.”

The jobs report was the last major look at the labor market before the Federal Open Market Committee meets this month.

The upcoming holiday-shortened week has some economic reports due out, including purchasing managers’ surveys, a cursory look at regional conditions in the Fed’s Beige Book and weekly jobless claims data. US markets will be closed on Monday for Labor Day, and the most significant indicator ahead of the Fed meeting will be the release of the consumer price index on September 13.

But the market will scrutinize comments from a host of Fed officials who will speak publicly next week, including Cleveland Fed President Loretta Mester. She said on Wednesday that policymakers should raise the federal funds rate to above 4% by early next year and indicated that she does not expect rate cuts in 2023.

Greg Wilensky, head of U.S. fixed income at Janus Henderson, said he was also focused on the upcoming release of payrolls data from the Atlanta Federal Reserve ahead of its next policy meeting. On Friday, the Labor Department reported that average hourly earnings rose 5.2 percent in August from a year earlier. That was slightly less than the 5.3% expected by economists, but still indicated pressure on wages from a tight labor market.

“I’m in the camp of 4 percent to 4.25 percent of the final rate,” Wilensky said. “People are realizing that the Fed is not going to stop on softer economic data unless inflation weakens dramatically.”

The specter of aggressive Fed tightening has also hit stocks, leaving the S&P 500 down more than 17% this year. Although U.S. stocks rallied from June lows through mid-August, they have since given back much of those gains as bets on a looming recession and rate cuts from 2023 have been reversed.

“You have to remain modest about your ability to predict data and how interest rates will react,” said Wilensky, whose core bond funds remain underweight Treasuries. “The worst is over as the market does a more reasonable job of pricing where prices should be. But the big question is what happens to inflation?

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