The peak in bond yields that seemed imminent has disappeared from view

(Bloomberg) — All bets on how high yields can rise in the world’s largest bond market appear to be off.

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Although the two-year yield only hit a new multi-year high this week — on Friday after October labor market data came in stronger than expected — more bloodshed seems inevitable in the government bond market.

Federal Reserve Chairman Jerome Powell reiterated on Wednesday, after the central bank’s sixth rate hike this year to a range of 3.75% to 4%, that there is no end in sight as long as inflation remains high. Swap traders responded with pricing at a peak rate of more than 5%.

“The data would have to be very bad to move the Fed off their current path,” said George Goncalves, head of U.S. macro strategy at MUFG. So “the risk/reward profile for and distortion in the bond market has shifted to further weakness.”

For now, investors remain convinced that the Fed is on a course that will eventually bring the economy to its knees. This is evident in the difference between yields on two-year and longer-dated Treasuries.

The two-year note surpassed the 10-year Treasury yield by as much as 62 basis points this week, the deepest inversion since the early 1980s, when then-Fed Chairman Paul Volcker relentlessly raised rates to tame hyperinflation. Curve inversions have a history of prior economic downturns of 12 to 18 months.

The inversion has the potential to widen to 100 basis points if the market begins to price in a terminal rate of 5.5 percent in response to future inflation readings, said Ira Jersey, chief U.S. interest rate strategist at Bloomberg Intelligence.

The 2-year peaked this week near 4.80%, while the 10-year has yet to exceed 4.34% in the current cycle and ended the week at 4.16%.

Total yields are likely to top 5% as the Fed continues to tighten financial conditions, said Ben Emmons, global macro strategist at Medley Global Advisors.

“Now it’s about the final destination” of the key rate, said Michael Gapen, chief U.S. economist at Bank of America Corp., whose forecast for the final level is in the 5%-5.25% range. “The risk is that they end up having to do more than we all think and it takes longer to get inflation under control.”

Money market traders remain divided on whether the Fed’s next meeting in December will result in a fifth straight rate hike of three-quarters of a point or less of a half-point move. Powell this week reiterated that the pace of increases would likely slow at some point, possibly as early as December. But with October and November inflation data scheduled for release in the meantime, it’s too early to tell.

Thursday’s October consumer prices are expected to show a slowdown. The 6.6% year-on-year increase in prices excluding food and energy in September was the largest since 1982 and pushed the Fed’s expected top rate above 5% for the first time.

Inflation data should dominate a holiday-shortened week in which there could be upward pressure on yields from resuming sales of government bonds, including 10-year and 30-year new issues. The trades, including a new 3-year bond, were the first in a year that were not reduced in size from recent comparables.

The Bloomberg US Treasury Index has lost nearly 15% this year. As stocks have also tumbled in 2022, investors in the popular 60/40 split between stocks and high-quality bonds have lost about 20%, according to a Bloomberg index.

However, hope springs eternal. Strategists at TD Securities on Friday recommended starting to buy 10-year Treasuries, expecting yields to fall as consumers drain savings and curb spending while the Fed keeps interest rates high.

“We are bullish on fixed income,” said Gene Tanuzzo, global head of fixed income at Columbia Threadneedle Investments. “There is an important reset for the asset class, especially if yields can stay higher. A lot of tightening has been done.”

What to watch

  • Economic calendar

    • November 8: NFIB Small Business Optimism

    • November 9: MBA mortgage applications; wholesale inventory

    • November 10: CPI; weekly unemployment claims

    • November 11: Michigan Sentiment and Inflation Expectations

  • Fed calendar:

    • November 7: Boston Federal Reserve President Susan Collins; Cleveland Federal Reserve President Loretta Mester; Richmond Federal Reserve President Thomas Barkin

    • November 9: New York Federal Reserve President John Williams; Barkin

    • November 10: Fed Governor Christopher Waller; Dallas Federal Reserve President Lori Logan; Master; Kansas City Federal Reserve President Esther George

  • Auction calendar:

    • November 7: 13-, 26-week bills

    • November 8: 3 Year Notes

    • November 9: 10-year notes; 17-week bills

    • November 10: 30-year bonds; 4-, 8-week accounts

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