(Bloomberg) - Strong market shocks are usually followed by tremors -- and the ones that rattled the Treasury market over the past week will likely be no exception.
Bond investors were hammered Thursday when inflation accelerated more than expected to another four-decade high, leaving Wall Street traders swiftly ratcheting up bets the Federal Reserve will begin an aggressive series of interest-rate hikes starting next month.
Then late Friday came just as jarring an about-face: Treasuries rallied sharply as U.S. officials warned that Russia soon could take military action against Ukraine, sending investors shifting cash into havens. Russia has repeatedly denied it plans an invasion.
The late-week whiplash underscored the volatility that’s been racing through the U.S. bond market, driving up short-term rates, flattening the yield curve and even briefly inverting 10-year and 7-year rates as investors try to gauge the path forward. The week’s swift repricing of short-term notes -- which was only partially rolled back on Friday -- has investors quickly refocusing on longer-dated bonds and how they may be affected by the Fed’s plans to start reducing its balance-sheet holdings.
“Investors have to realize that this is going to be a very choppy market and they have to be cautious with their position,” Richard Saperstein, chief investment officer at Treasury Partners, said in an interview with Bloomberg Television Friday.
The selloff that erupted in the wake of the Thursday report showing that consumer-price increases accelerated to a 7.5% annual pace in January hit the shortest-dated securities the hardest as investors repriced expectations for the Fed’s trajectory, with two-year Treasury yields seeing the biggest one-day jump since 2009.
At the same time, the gap between 5- and 30-year yields narrowed to less than 40 basis points, the smallest since the Fed was at the end of its last rate-hike campaign in 2018. That signaled speculation that economic growth will slow as the Fed tightens monetary policy.
The shrinking gap left strategists looking to the release of the Federal Open Market Committee meeting minutes Wednesday for clues on how the Fed will start reducing its $9 trillion of asset holdings, another tool it’s planning to use to pull support from the financial system. It’s possible the central bank could use that so-called quantitative tightening to prevent long-term yields from slipping below short-term ones -- resulting in an inverted yield curve -- by strategically paring its holdings of particular securities.
“I think the story is about QT and maintaining a positive-slopping yield curve,” said Mark Holman, chief executive officer at TwentyFour Asset Management, a London-based investment firm that specializes in fixed-income securities.
The week’s flattening of the yield curve highlighted the Fed’s balancing act as it seeks to curb inflation without derailing the economic expansion. The so-called bearish flattening, which Thursday pushed the 10-year yield above 2% for the first time since 2019, typically occurs when the bond market believes the central bank is behind the curve and needs to act so aggressively that growth could halt.
The swaps market has started expecting the Fed to raise its key overnight benchmark steadily over the course of its seven meetings this year. Such a course could allow growth to cool and inflationary pressures to ease and helps explain the limited rise in long-term yields.
But Fed officials have also been mindful of the negative signal an inverted yield curve sends, one that can be a self-fulfilling prophecy if investors start pulling back in anticipation of a recession.
“The Fed probably does not want an inverted, flat yield curve sooner than later, so that makes their plans for the balance sheet a very important topic for the bond market and the ultimate path of 10-year yields,” said Kevin Flanagan, head of fixed-income strategy at WisdomTree Investments Inc.
A flat or inverted yield curve -- which could happen if markets start pricing in more short-term rate hikes -- could further heighten the Fed’s use of its balance sheet to tighten monetary policy. It typically reduces holdings by not reinvesting the proceeds of maturing securities, though it could also choose to sell bonds to drive up long-dated yields.
“The curve has moved a hell of a long way and this flattening is definitely a concern for the Fed,” said TwentyFour’s Holman. “If the Fed really wants to effect the yield curve they are going to have to sell assets. Because just letting debt run off means it’s just going to run off on the short end. If they want to steepen the curve they are going to have to sell things.”
What to watch
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Economic calendar:
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Feb. 15: Producer prices; Empire manufacturing; Treasury international capital flows
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Feb. 16: MBA mortgage applications; retail sales; import/export prices; industrial production; business inventories; NAHB housing index; FOMC minutes
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Feb. 17: Building permits/housing starts; jobless claims; Philadelphia Fed business outlook
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Feb. 18: Existing home sales; leading index
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The Fed calendar:
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Feb. 14: St. Louis Fed President James Bullard speaks on CNBC
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Feb. 16: FOMC Minutes; Minneapolis Fed President Neel Kashkari
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Feb. 17: Bullard; Cleveland Fed President Loretta Mester
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Feb. 18: Fed Governor Christopher Waller; Chicago Fed President Charles Evans; New York Fed President John Williams
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Auction calendar:
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Feb. 14: 13-, 26-week bills
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Feb. 16: 20-year bonds
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Feb. 17: 4-, 8-week bills; 30-year TIPS
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By Michael MacKenzie and Liz Capo McCormick
