Bond Bears Ask What's Next as Yields Plateau -- Quarter-End Report
By Daniel Kruger
Investors ended the quarter asking whether the Treasury market selloff has abated.
The yield on the benchmark 10-year U.S. Treasury note posted its third consecutive quarterly gain, boosted by surging expectations for growth and inflation in the wake of a $1.5 trillion tax cut passed at the end of last year.
Proponents of the tax cut said lower levies on corporations would lead to increases in business investment and worker wages, spurring demand and juicing inflation. Inflation undermines the value of bonds by eroding the purchasing power of their fixed interest payments and their principal.
Data showed wages and consumer prices rose in January, encouraging more investors to sell government bonds and driving the yield on the benchmark 10-year Treasury more than half a percentage point higher in less than two months. Yields rise as bond prices fall.
But the rise in yields stalled in March. The strong January wage data was revised lower in the following month's labor report. Subsequent weaker-than-forecast inflation data suggested the tax cuts were unlikely to spur growth that matched the move in market expectations. Bonds also attracted buyers as rising yields have spooked some stock-market investors, leading to a surge of volatility in financial markets after a placid 2017.
"The move is in some ways very similar to what we saw after the election" as expectations for acceleration of growth and consumer prices sent investors pouring into stocks and out of bonds, said Wan-Chong Kung, a bond fund manager for Nuveen. "There's been some tempering of this inflation optimism," she said. "There's some healthy skepticism about growth."
The most recent inflation data showed a loss in momentum. The Labor Department said on March 13 that the consumer-price index, which measures what Americans pay for everything from laundry detergent to motorcycle helmets, rose 2.2% year over year in February, below the 2.3% estimated by economists surveyed by The Wall Street Journal. Core prices rose 1.8% for a third consecutive month, also below economists' expectations.
The 10-year yield reached a four-year peak at 2.943% on Feb. 21, and has since fallen to 2.741%. The increase of 0.332 percentage points was the largest for a quarter since December 2016.
Investors will head into the second quarter looking for signs of whether Federal Reserve officials are edging closer to signaling a fourth interest-rate increase this year. After policy makers raised interest rates at their March meeting, the officials' forecasts showed they are moving closer to the view that they should accelerate the pace of rate increases this year.
Most Fed officials still expect to raise rates no more than three times this year. While policy makers forecasting four rate increases in 2018 remained short of a majority, that cohort of central bankers grew to seven in March from four in December. Policy makers also boosted their projections for the pace of rate increases in both 2019 and 2010.
Those forecasts notwithstanding, many investors said they thought Fed Chairman Jerome Powell showed a bias toward a slower approach to raising interest rates in his first news conference speaking for the central bank. Fed-funds futures, which investors use to bet on central-bank policy, late Thursday showed the chances that the Fed will boost rates for four times this year at 32%, compared with 31% a week before, according to the CME Group.
"The Fed's going to have to be convinced to go to four, and right now I'm not seeing this," said Andrew Brenner, head of global fixed income at NatAlliance Securities. "I'd be leaning more towards two than four."
The rising supply of short-term debt being sold at the same time the Fed is raising interest rates is pushing up two-year yields in relation to the 10-year yield, leading to a smaller gap between two- and 10-year Treasury yields. That gap, known as the yield curve, is sometimes seen by investors as a measure of economic health, with steeper, more positively sloped curves signaling a better growth outlook.
Investors also are grappling with the relationship between stock prices and bond yields, as an array of crosscurrents are adding to the uncertainty about the direction of financial markets. Rising bond yields in February helped instigate a tumble for stocks as investors became increasingly concerned that the climb might curtail economic growth and reduce the appeal of stocks in analysts' valuation formulas, which often consider bond yields.
At the same time, investors are trying to assess how the economy will respond to a weakening dollar, rising oil prices and bond-market credit spreads. With the yield gap between corporate bonds and Treasurys narrowing during the economic expansion, a reversal in that trend could signal problems for the economy.
"There are enough reasons to think that volatility is here to stay for the rest of 2018," said Daniela Mardarovici, who helps manage the BMO TCH Core Plus Bond Fund.
Write to Daniel Kruger at Daniel.Kruger@wsj.com