All it took was one hot inflation report to convince the bond market that the Federal Reserve might really raise interest rates three or more times this year and several more next year.
Treasury yields, which move opposite price, rose after core consumer prices jumped 0.349 percent, the most on a monthly basis since March 2005. Core inflation is now running at a three-month annualized average of 2.88 percent, the highest since 2008.
Stock traders have been keeping an eye on the benchmark 10-year yield, but the action in the Treasury market Wednesday was spread up and down the curve, with the biggest moves in the 5- and 7-year sectors and the smallest at the top. Even as yields moved up, the stock market continued to gain, opposite recent sessions where higher interest rates spooked equities.
“This keeps the March hike in play and we’re shifting from steepening the [10-years] and [30-years] to more steepening in the 5-year sector. The market may be thinking perhaps they’re going to hike more in 2019,” said George Goncalves, head of fixed income strategy at Nomura.
The wild card for the bond market is the stock market. If stocks weaken, bonds could see a bout of buying that would send yields lower again, as has been the case during the last two weeks of extreme volatility.
The Fed has forecast three rate hikes for this year and another three for next year, but economists have been changing their forecasts for this year to include another rate hike. For months, the markets stubbornly priced out the Fed’s forecast for three rate hikes this year and more next year, but it is beginning to adjust. As of Wednesday, there were 2.7 rate hikes priced in for this year and one for 2019.
“All the market hinges on are the inflation prints. Inflation data is the driver of the bond market at this point, I believe,” said Ralph Axel, U.S. rate strategist at Bank of America Merrill Lynch. The Fed “could have three this year and three next year, and that’s what the whole debate in the market is about.”
Ian Lyngen, head of rate strategy at BMO, said the data has given the Fed’s forecasts more credibility.
“The market is not treating it like it’s going to be any more quickly. What the market is saying is there’s a higher probability that the Fed could go longer,” Lyngen said. “The market believes the Fed has a higher probability of reaching their target terminal rate for this cycle, which is roughly 3 percent.”
The fed funds rate is currently at 1.42 percent. The Fed is expected to raise its target rate by a quarter point to 1.5 to 1.75 percent in March.
Yields continued to move higher in afternoon trading, with the 10-year touching 2.91 percent, the highest since January, 2014. The 7-year was close behind at 2.82 percent, the highest since April, 2011. The 5-year was at 2.63 percent, the highest since 2010 and the same level that was the high yield for 10-year notes through all of last year.
“It really is the Fed getting priced in,” said Axel. “At the end of 2019, after the September meeting, the market’s got 2.32. The funds rate now is 1.42 percent. You’re not even looking at 100 basis points between now and the September meeting of next year.”
Axel said the bond market’s expectations will depend on the next inflation reports. There is the producer price index Thursday, but the market is not expected to react to it as much as to the consumer data.
“If you have a string of these. you start increasing the annualized rate quite quickly. It could change the picture for the Fed. You could price in four for this year…four [in 2019]. That would be normal. The return to the old normal. That’s the debate in the market,” he said. “Are we stuck in a new normal or are we going back to the old normal? Nobody knows for sure but each little data point pushes us one way or the other. This pushes us more toward that old normal.”
The next significant event that could help the market price for the Fed’s policy moves is the congressional testimony Feb. 28 by new Fed Chairman Jerome Powell. Powell testifies on the economy and that will be the first major event where he will be speaking.
“I think you’re going to continue to see higher rates until Powell shoots something across the bow. He either gets rates going higher or he slows it down,” said Andrew Brenner of National Alliance. Brenner said he believes the 10-year could get to 3 percent rather quickly. That is a level that some stock analysts say could be a problem for the stock market.
Goncalves said he believes the near-term move is nearly completed for now.
“We should be in a range,” he said. He expects the 10-year to trade between 2.90 and 2.93 percent. “We’re building a near-term top. I still think we’re going to go above 3 percent, but not now. I think we have to get through the Fed hike and Powell’s speech on the 28th.”