Bond bulls ignore the noise of the Fed’s rate hike and continue to buy peak yields

(Bloomberg) – For over a year, bond traders have been plagued by uncertainty about how much the Federal Reserve will hike interest rates.

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But that is now giving way to a growing conviction that longer-dated government bond yields have likely already peaked – and that unexpected sell-offs, giving yields an extra boost, appear to be good times to buy.

The shift could bring some stability to a bond market that has consistently been surprised by the resilience of the US economy after the Fed hiked interest rates by five percentage points since March 2022. Momentum was added on Friday as bonds slipped after a report showed employers unexpectedly accelerated the pace of hiring in May.

At the same time, a slowdown in wage growth and a rise in the unemployment rate suggest that the central bank may finally steer the economy into a downturn, albeit hopefully relatively gently. This could effectively cap long-term bond yields, even as short-term bond yields remain volatile as traders try to play out the final moves of the Fed's monetary tightening campaign.

“The 5-year and 10-year bonds were the sweet spot for us and we bought there,” said Scott Solomon, fixed income portfolio manager at T. Rowe Price.

The focus now shifts to the next CPI release on June 13, when the Fed begins its two-day monetary policy meeting. According to economists polled by Bloomberg, the gauge is expected to show that the pace of inflation slowed to 4.1% yoy in May in May, which could provide potential support for policymakers to delay further rate hikes until July.

Expectations of the Fed taking such a pause helped push two-year Treasury yields lower ahead of Friday's payrolls report, to be slightly below 4.5% on the week despite a sharp rebound immediately after jobs data . Both Fed Governor Philip Jefferson and Philadelphia Fed President Patrick Harker showed their support for the hold-back in some closing comments from officials ahead of the meeting ahead of the lockdown.

As of late Friday, derivatives were showing a quarter point gain this month or next, which was far from certain, but the odds that that would be the case for the session ending June 14 are slim less than one in two. Traders also squeezed out almost all of the interest rate cuts that were still expected in the final stages of 2023 last month.

Central bank officials' new forecasts for interest rate developments, due to be released at the next Federal Reserve Open Market Committee meeting, should strengthen the view that a pause in June does not mean the end, especially if inflation continues to ease slowly.

“If they really think they're coming back after June, they may need to put some higher signals, probably another up in the scatter chart,” said Alex Li, head of U.S. rates strategy at Credit Agricole, referring to the nickname for the Summary of forecasts.

Longer-dated bonds were less affected by speculation about the Fed's next move, as investors believed there was ultimately not much left to do.

Additionally, yields have risen sufficiently from pandemic-era lows that they now offer decent yields. And there's a chance fixed-income asset prices would rise if the economy slips into a recession that would force the Fed to reverse.

This has helped contain longer-term returns. When the selling pressure was sparked earlier by stronger-than-expected economic numbers, buyers rushed as 5-year and 10-year yields rose to 3.99% and 3.86%, respectively, to their highest levels since the banking turmoil in early March. JPMorgan Chase & Co. Treasury's latest client survey showed long positions hit the highest level since last September.

Ten-year government bond yields were around 3.69% for the week, down around 10 basis points from the week before, despite support on Friday. The five-year return was around 3.84%.

Jack McIntyre, a portfolio manager at Brandywine Global, said he would not change his fixed income positioning based on the latest jobs data. The company has a large inventory of longer-term debt that “will do well in a soft landing and a recession.”

“They want things that are defensive and yielding,” he said.

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