With growing concerns about U.S. inflation, some investors are bracing for the 10-year U.S. Treasury yield to surpass the 16-year high of 5% reached last October.
Bond yields, which move inversely to prices, have been rising recently as signs of persistent inflation dampen expectations for how much the Federal Reserve can lower interest rates without further stoking consumer prices. The yield on the benchmark 10-year note has climbed by 80 basis points this year and currently stands at 4.70%, marking a five-month high.
Many investors anticipate further weakness in bonds. According to the latest BofA Global Research survey, global fund managers’ fixed income allocations are at their lowest level since 2003.
BofA data also indicates that bearish Treasury positioning among certain classes of hedge funds is at its highest level of the year, despite increased bullish bets from other asset managers.
“Inflation is the key factor here. If the market doesn’t see signs of inflation being controlled, then there’s no reason why yields won’t continue to rise,” said Don Ellenberger, senior portfolio manager at Federated Hermes. He has reduced his portfolio’s interest rate sensitivity, wary that persistent inflation and a strong labor market could push yields up to 5.25%.
Further evidence of rising inflation emerged on Thursday with data showing that the Personal Consumption Expenditures (PCE) price index, excluding food and energy, increased more than expected in the first quarter.
Futures markets now indicate that investors expect the Fed to implement only 35 basis points in rate cuts this year, compared to over 150 points priced in at the beginning of 2024.
Another inflation report on Friday, when PCE data for March will be released, could further diminish expectations for rate cuts this year. More insights on the economy could be gleaned from the conclusion of the U.S. central bank’s monetary policy meeting on May 1.
Treasury yields are closely monitored by market participants, as higher yields can lead to increased borrowing costs for consumers and businesses and tighten financial conditions in the economy.
A surge in yields during the latter part of 2023 triggered a sell-off in the S&P 500, although equities rebounded when yields reversed. This year, the rally in stocks has faltered as yields have risen, with the S&P 500 paring its gains to around 6% year-to-date, from over 10%.
While some investors have seized the opportunity to bolster their fixed-income holdings amid bond weakness, others remain skeptical that inflation will ease anytime soon.
“Inflation is not subsiding as the Fed expected,” said Arthur Laffer, president of Laffer Tengler Investments, who is bearish on longer-dated Treasuries and believes yields could climb as high as 6%.
Michael Purves, head of Tallbacken Capital Advisors, suggested that if higher prices for oil and other raw materials persist, it’s conceivable that the 10-year Treasury yield could reach its 2007 high of 5.22%.
Fiscal concerns, including rising debt levels, could also push yields higher. Fitch downgraded the U.S. credit rating last year partly due to these concerns.
Many investors anticipate an increase in term premiums – the compensation demanded to hold long-term debt. However, some believe that a return to 5% yields would mark a peak for investors.
Alex Christensen, a portfolio manager at Columbia Threadneedle Investments, who is overweight two-year Treasuries, noted that the market narrative has been one-sided since the Fed pivot in December, leaving little room for changes in the inflationary trend.
“We believe the general inflationary trend is stable to lower,” Christensen said, expressing doubt that the Fed will pivot towards rate increases.
