(Bloomberg) -- Treasury bondholders are hoping for a reprieve after the most brutal three months of modern times.
The swift selloffs that ripped through the market as traders braced for a more aggressive series of interest-rate hikes from the Federal Reserve hit investors with a loss of 3.1% in March, Bloomberg's index shows. That's the steepest monthly drop since 2004 and caps the worst quarter for Treasuries since the index starts in 1973, surpassing the rout seen when the central bank was fighting a wage-price spiral in 1980. Even inflation-adjusted Treasuries, which have served as a haven, have lost 2.7% since the start of the year.
But the scale and speed of the drop has pushed up yields far more than at the start of other monetary-policy tightening cycles, with those on two-year Treasuries jumping to as much as 2.45% from 0.73% at the end of last year. That's effectively priced in the approximately 2 percentage points of rate increases the central bank is expected to make over its remaining six meetings this year, leaving the market potentially poised to steady over the next few months -- or at least staunch the bleeding -- unless a worsening inflation outlook drives the Fed to tighten more quickly.
“The bond market has just priced in a full tightening cycle by the Fed and is in the process of defining the upper end of the range in yields,” said Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets. “At the start of the first quarter, the market typically expects higher yields and then by May we tend to have a better sense of how the economy and inflation is behaving. What took us by surprise this year was just how hawkish the Fed became.”
The trajectory of the world's biggest bond market in the coming months will depend heavily on whether yields have risen far enough to draw in domestic buyers and foreign investors such as those in Japan, given that rates are on the rise worldwide. It will also hinge on whether data signal that the steepest inflation since the 1980s is becoming ingrained in the economy.
“It's been an incredibly challenging quarter, and the million-dollar question is how aggressive does the Fed need to be in order to get inflation under control,” said Jason Callan, senior portfolio manager at Columbia Threadneedle. He expects the pressure on the market to ease during a holding pattern over the next few months as the Fed keeps raising rates and moves toward scaling back the asset holdings on its balance sheet. “We need to see a softening in the inflation numbers that creates an opportunity for the Fed to pivot and relax its hawkish stance. Only then will investors get comfortable with exposure to Treasuries.”
The Treasury market has started to steady from this month's selloff, with benchmark 10-year yields poised for the first weekly drop since early March. But the relief could prove short-lived as some investors brace for further declines.
Scott Thiel, the chief fixed-income strategist BlackRock Inc., said the company is still underweight bonds, expecting that the pace of inflation will drive up long-term yields further as investors demand higher compensation to offset it.
“We have only seen a hawkish pivot and expect a higher term premium and a steeper yield curve this year,” he said. “The trigger to buy bonds will come later this year when the Fed has tightened and is close to a neutral policy rate.”
So far, that term premium -- or the extra yield investors demand for the risk of holding longer-term debt -- has collapsed. The difference between 2- and 30-year yields has dropped to about 0.16%, the smallest since 2007, while the gap between 2- and 10-year yields on Tuesday briefly turned negative. In the past, that sort of inversion has signaled expectations that the economy is headed toward a recession.
The flattening trend and relatively modest long-term inflation expectations have supported appetite for 30-year bonds from some investors, such as pension funds, which have solid funding ratios in the wake of strong stock-market gains during 2021 and 2020. Strategists at Morgan Stanley this week said trading patterns suggest that “pensions are back in de-risking mode,” and “to the extent it continues on the back of improved funding ratios, is likely to keep putting flattening pressure on the curve.”
Another factor supporting the long-end is that the 30-year bond yield recently rose above the Fed's long-run estimate of 2.37% for its benchmark rate. “That has usually been a pretty good barometer for buyers,” said Columbia Threadneedle's Callan.
But he remains wary of policy-sensitive two and five-year notes because the Fed and other central banks may need to stay hawkish and seek a further tightening in financial conditions. In spite of the sharp climb seen in Treasury yields during March, equities and high-yield bonds have lately rallied, alleviating some of the overall tightening of financial conditions and raising the prospect of central banks having to push harder in their fight against inflation.
“The elephant in the room is whether inflation rolls over,” said James Paulsen, chief investment strategist of The Leuthold Group. He said a decline in the annual pace of consumer-price increases to around 5% in the coming months from a current level of some 8% would “take the starch out of rising yields and how much the Fed needs to tighten.”
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