Bond Rally delivers early win for Wall Street’s yield curve bet for 2023

(Bloomberg) – Bond market bulls are getting an early taste of what they expect to be a successful trade in 2023.

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On Friday, shorter-dated Treasuries led a broad market rally after the December jobs report showed a slowdown in wage growth and an indicator of the service sector economy contracted unexpectedly. The data fueled speculation that the Federal Reserve is nearing the end of its most aggressive rate-hike cycle in decades and could start easing monetary policy by year-end.

The rally reduced the inversion of key Treasury yield curves – the gaps between short and longer-term interest rates that are closely watched as potential recession signals. Such moves, known in market jargon as curve steepening, were widely expected this year, giving investors battered by market volatility at least a temporary win.

“The steepening yield curve we saw post-payroll reflects a sigh of relief that strong wage increases are likely behind us, which is good news for the Fed,” said Alex Li, Credit’s head of U.S. interest rates strategy Agricole. “They are probably closer to the end of the tightening cycle, although they still have a lot to do.”

It is far from certain that the Treasury market’s recent moves will continue given how volatile the market has been, and long-term yields are still well below short-term amid uncertainty about the outlook. In addition, a major disconnect remains between financial markets and Fed officials, who have stressed that they are likely to keep raising rates – and will keep them there – until inflation returns to the central bank’s 2% target.

The story goes on

Priya Misra, head of global interest rate strategy at TD Securities, said the market is wrong in pricing a return to Fed rate cuts. In her view, the Fed is likely to raise interest rates to around 5.5% and stay there all year, which she thinks could push the 10-year yield even further below the 2-year benchmark than before. The Fed’s interest rate is currently in a range of 4.25-4.5%.

“Recession fears will increase demand at the long end,” Misra said.

There is another risk that could turn bullish bets on the yield curve upside down. If data shows that inflation remains persistent and the economy resilient, Treasury yields could continue to rise as now expected easing is priced out by the market.

Dealers have not adjusted to this. Both the 2-year and 10-year yields – now around 4.25% and 3.56% respectively – are both well below the expected peak for the fed funds rate this year. On Friday, 2- to 5-year government bond yields fell by 21 basis points or more, about twice as much as 30-year yields.

Swap traders are pricing in that the Fed will keep raising interest rates until it’s just below 5% around June, before lowering it to around 4.5% by year-end.

That view could be put to the test in the coming week when December’s consumer price index shows inflation came in faster than expected, with economists forecasting it to remain unchanged from the previous month. Investors will also pay close attention to public appearances by Fed officials, including Chairman Jerome Powell.

“If the economy can handle higher interest rates and doesn’t tip over once the Fed tightening is complete, the back end will normalize as recession fears subside,” said Greg Peters, co-chief investment officer of fixed income at PGIM. That “is a possible scenario and nobody is talking about it.”

Something to see

Economic calendar:

• January 9th: consumer credit

• Jan 10: NFIB Small Business Optimism; Wholesale Sales and Inventory

• January 11: Mortgage applications

• Jan 12: Consumer Price Index; weekly unemployment claims

• Jan 13: Import and Export Price Indices; University of Michigan sentiment poll

• Fed calendar:

  • Jan 9: Atlanta Fed President Raphael Bostic

  • January 10: Chairman Powell at the RiksBank event

  • Jan. 12: Philadelphia Fed President Patrick Harker; St. Louis Fed President James Bullard

• Auction calendar:

  • January 9: 13-week, 26-week bills

  • January 10: 3-year bonds

  • Jan 11: 10-year bonds; 17 week bills

  • January 12: 30-year bonds; 4 week, 8 week bills

–Assisted by Elizabeth Stanton.

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