Written by Davide Barbuscia
NEW YORK (Reuters) – A rethink of when the Federal Reserve will cut interest rates is resonating in the fixed income market, raising risks for those betting that the explosive rally that sent bonds soaring at the end of 2023 will continue this year.
Investors piled into Treasuries late last year amid expectations that the Federal Reserve would cut interest rates in the first quarter of this year, sending government bond prices up from 16-year lows.
Many are now recalibrating those bets in the wake of massive US jobs numbers and a dovish message from the Federal Reserve, which said last week that a strong economy could spur an inflationary rebound if interest rates are cut too early. Yields on the benchmark 10-year Treasury note, which move inversely with the price, have risen in recent days and now stand 20 basis points above their December lows.
While investors still expect the Fed to make a number of interest rate cuts this year, they are now less confident about when the central bank will start lowering borrowing costs and how far interest rates will fall. Concerns about the expected rise in the supply of bonds resulting from the government issuance are also dampening bulls’ enthusiasm.
“The combination of the jobs numbers and the Fed’s press conference really split the potential outcomes,” said Robert Tibb, chief investment strategist and head of global bonds at PGIM Fixed Income, which manages $794 billion in assets.
He believes 10-year bond yields this year could approach last year’s highs of about 5%, from their current level of about 4.1%.
Futures contracts tied to the Fed’s interest rate late Tuesday showed investors assigning a roughly 20% chance the Fed will cut interest rates in March, down from 64% a month ago, CME Group data showed.
Federal Reserve Chairman Jerome Powell downplayed expectations for a March cut at the end of a monetary policy meeting last week, saying officials needed more confidence that inflation was heading toward its 2% target. He reiterated his views during an appearance on CBS’ “60 Minutes” on Sunday.
Meanwhile, the probability of a first rate cut in May rose to 55% from 37% a month ago. Investors are now pricing in a total of 122 basis points of cuts in 2024, from around 150 basis points in mid-January.
John Madzire, head of U.S. Treasuries and Mutual Funds at Vanguard, the world’s second-largest fund manager, said that before the Fed’s policy meeting last week, he expected to “buy the dip” if 10-year bond yields reached 4.25%.
“Now we may start to expand at 4.25% on the basis that we potentially reach 4.5%, with pricing…a higher scenario in the long term,” he said.
For others, the decline in Treasuries confirmed suspicions that last year’s rally was overdone.
Spencer Hakimian, CEO of Tolou Capital Management, a New York-based hedge fund, has trimmed exposure to long-term Treasuries in recent weeks and added shorter-term bonds amid expectations that interest rates will remain high for longer than markets had expected.
“We are more exposed to the front end of the curve because we think the interest rate risk is much lower there,” he said. The risk of rising interest rates reducing the value of bond yields is greater for longer-term bonds.
An expected $2 trillion in new US government bond issuance this year is also making investors cautious, with many believing yields must rise in order to attract buyers. US financial concerns exacerbated the sell-off in Treasuries in October, and rating agencies Fitch and Moody’s warned last year of the burden of higher interest rates on state coffers.
Matt Egan, a portfolio manager at Loomis, Sayles & Company, expects 10-year yields to be 4.5%, partly due to the expected large government issuance.
So far, the rise in yields has had little impact on stocks, in contrast to the sell-off in stocks that spiked Treasury yields in September and October. The S&P 500 is up more than 4% this year and stands near a record high.
At the same time, many still believe interest rates will trend lower, as long as inflation remains in a calm direction. Last December, Federal Reserve officials expected interest rate cuts of a quarter of a percentage point this year, an outlook that Powell recently said was still likely to be in line with the views of policymakers.
Strong economic data changes the Fed’s timing but not its direction, said Jason Pride, head of investment strategy at Glenmede.
He added: “This does not mean that they cannot lower interest rates, it just means that their pace is a little slower.”
(Reporting by Davide Barbuscia; Editing by Ira Iosibashvili and Anna Driver)
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