(Bloomberg) — The $31 trillion Treasury market has an unequivocal message for Kevin Warsh’s Federal Reserve: Interest rates aren’t high enough.
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Yields on policy-sensitive US two-year notes have surged to their highest level in more than a year after a trove of economic data led traders to price in at least one quarter-point rate hike as soon as October. At around 4.15%, the two-year yield trades well above the Fed’s current policy band of 3.5% to 3.75%, a divergence that began in March.
The reset upwards only intensified last week after the latest read on job growth topped all forecasts, reinforcing a growing conviction that rates need to rise in order to rein in inflation pressures and temper the risk of an AI-induced boom overheating the economy. Reports due later this week on consumer and wholesale prices in May are expected to provide further validation of the narrative.
“Show me where rates are being restrictive,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. “Treasury yields are going to be biased higher until something breaks.”
The rise in US yields has extended across the entire Treasury curve, creating a charged backdrop for Fed policymakers and their new chairman, Kevin Warsh, who helms his first meeting and press conference next week.
Having advocated the case for easing rates based on the view that policy was restrictive, Warsh now faces a bond market increasingly concerned the Fed may be getting behind the curve, and a number of central bankers who are also worried about inflation and don’t rule out rate hikes in the future.
Brandywine’s McIntyre said his firm remains underweight interest-rate exposure in the US and doesn’t see super-compelling value in bonds, given the economy’s resilience. Others see the economy at risk of going into over-drive.
“For the first time in a while, we are considering a scenario where the US economy actually starts overheating,” said Andrzej Skiba, head of BlueBay US fixed income at RBC Global Asset Management, citing a ramp up in artificial intelligence spending into an already-robust economy.
Skiba said the scenario isn’t his base case, adding he’s keeping his interest-rate exposure close to benchmarks as he waits to see whether Warsh comes out as dovish or hawkish.
Story Continues
The divergence between US short-term yields and policy rates echo how the market ran ahead of Fed policy from late 2021 and through early 2022, when the central bank eventually followed with a series of chunky rate hikes to combat a surge in inflation.
It also focuses attention on the Fed’s long-run measure of its “neutral rate,” a theoretical level of borrowing costs that neither stimulates nor slows growth, and whether it needs an upward adjustment.
Shifting Assumptions
In March, Fed officials’ forecast of their longer-run rate, seen as a proxy for the neutral rate, was 3.1%. This supported policymakers’ bias, as of their latest meeting, toward lower rates. But some market watchers argue it’s actually higher, as evidenced by the unrelenting spending spree fueling activity around the AI buildout. So a hawkish policy response may be required instead.
“The debate is now shifting to whether the labor side of the mandate is accelerating and whether monetary policy is even restrictive to begin with,” wrote Barclays Plc’s rates strategy team led by Anshul Pradhan in a note after Friday’s jobs data. “If not, the underlying neutral rate assumption also needs to shift higher. Such a repricing would affect the entire yield curve, not just the front end.”
A swaps-based measure of the market’s assessment of the inflation-adjusted neutral rate is about 1.8%, and higher than the median Fed estimate of 1.1% for the neutral rate after inflation.
Where Warsh sees the neutral rate “is a very fair question and an important one to ask,” said Kevin Flanagan, head of investment strategy at WisdomTree. Warsh’s predecessor, Jerome Powell “was kind of hemming and hawing, that 3.5% could be neutral,” and “so it is fair to say policy is maybe at neutral right now and that it is not restrictive anymore.”
To a degree, higher Treasury yields are doing some tightening for the Fed, with a 10-year trading around 4.5% pushing up the cost of mortgages and corporate borrowing. Bloomberg Economics estimates the recent rise in yields is equivalent to about 75 basis points of Fed rate hikes.
That could support the Fed standing pat.
On Wednesday, the release of consumer price index data for May has the potential to shift rates and Fed policy expectations as traders see to what degree the Iran war-fueled oil price surge feeds more broadly into this measure of inflation. Data that comes in tamer than expected may ease concerns somewhat. But with inflation still running above the Fed’s target, it wouldn’t change the overall story by much.
“If the CPI doesn’t show clear escalation in inflation, then there’s limits as to where the selloff is going to go and you can actually make a case, that maybe you get a little mini relief rally,” Flanagan said. “But the bottom line message for the Treasury market is that a 4% handle should now be more of the norm across the coupon curve.”
The yield on US 10-year debt was one basis point lower at 4.55% at 4:35 a.m. in New York.
–With assistance from Ye Xie.
(Adds level of US 10-year yield in the final paragraph)
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