Treasuries Drop as Yield Curve Flattens on Fed Forecasts

Treasuries fell, pushing five-year yields to a one-year high, after the Federal Reserve maintained guidance to keep interest rates low for a “considerable time” and raised its estimate of the target rate for overnight loans between banks for 2015.

The difference between yields on two- and 30-year Treasuries narrowed from a one-month high as officials increased their median estimate for the federal funds rate at the end of 2015 to 1.375 percent, compared with 1.125 percent in June. Policy makers decreased the monthly pace of debt purchases by $10 billion for the seventh consecutive meeting, with the intention of ending them after October.

“The Fed is certainly moving forward with plans to normalize interest rates,” said Kathy Jones, a fixed-income strategist at Charles Schwab & Co. in New York. “The median estimate for the fed fund’s rate at the end of 2015 has edged up. That’s a pretty decent move up.”

The five-year note yield added six basis points, or 0.06 percentage point, to 1.83 percent at 5 p.m. in New York, the highest since Sept. 6, 2013, according to Bloomberg Bond Trader prices. The 1.625 percent note due in August 2019 rose 1/4, or $2.50 per $1,000 face amount, to 99 1/32. Yields on benchmark 10-year notes rose three basis points to 2.62 percent.

The difference between yields on two-year notes and 30-year bonds, or yield curve, narrowed three basis points to 280 percentage points after reaching 284, the most since Aug. 14.

‘Flatter’ Curve

“If you’re a longer-term investor, buy the 10-year area,” Jones said. “With a flatter yield curve, the risk/reward is probably a bit more attractive as you are earning income while awaiting the Fed’s” normalization.

The yield on the 10-year note may climb to 2.75 to 2.8 percent by year-end if the economy continues to show improvement, Jones said, and the two-year yield may climb to 70 basis points by year-end.

“Labor market conditions improved somewhat further” while “significant underutilization of labor resources” remains, the Federal Open Market Committee said today in a statement in Washington. “Inflation has been running below the committee’s longer-run objective.” In July, the Fed said inflation was “somewhat closer” to its goal.

The fed funds rate, at zero to 0.25 percent since 2008, will be at 3.75 percent at the end of 2017, the Fed said today for the first time as it included that year in its Summary of Economic Projections. That is the same as Fed officials’ longer-run estimate. The median estimate in June for the long-run rate was also 3.75 percent.

‘Sharper’ Trajectory

“Although they didn’t remove the language about the extended period of time, it looks like the trajectory of the policy rate -- once we have lift off -- may be sharper than the market anticipates,” said Jennifer Vail, head of fixed-income research of the Minneapolis based U.S. Bank Wealth Management, which oversees $112 billion. “I find it interesting and somewhat shocking in that they didn’t soften language around labor-market slack.”

The central tendency estimate for the longer-run growth rate ranged from 2 percent to 2.3 percent, compared with 2.1 percent to 2.3 percent in June. A year ago, Fed officials forecast the economy’s potential growth rate at around 2.2 percent to 2.5 percent.

Fed officials’ central tendency estimates for 2017 showed gross domestic product expanding at 2.3 percent to 2.5 percent, with the inflation, measured by the personal consumption expenditures price index, rising by 1.9 percent to 2 percent. The unemployment rate will average 4.9 percent to 5.3 percent in the final quarter of that year.

Committee Hawks

“It was the dots that people have gotten worried about,” David Ader, head of U.S. government-bond strategy at CRT Capital Group LLC in Stamford, Connecticut, said of the display of dots on a chart used by policy makers. “The curve here is really explaining it.”

Policy makers, such as the Boston Fed President Eric Rosengren and Philadelphia Fed President Charles Plosser, said earlier this month that they would like to change the central bank’s forward guidance in order to tie the first rate increase since the financial crisis to changes in inflation and the job market. Rosengren would prefer to keep rates low for longer, while Plosser has sought to raise them sooner.

Even after six years of monetary stimulus, the bond market is signaling the economy’s potential to produce the kind of growth that compels Fed Chair Janet Yellen to aggressively lift rates and curb demand for fixed-income assets has lessened.

Fighting Fed

Bond traders now see consumer prices increasing an average 2.38 percent annually over the five years starting 2019, based on the five-year, five-year forward break-even rate, a metric the Fed uses to gauge long-term inflation expectations.

The level compares with an almost three-year low of 2.33 percent reached June 20 and is also lower than at the end of both QE2 in June 2011 and the Fed’s first QE in March 2010, when inflation expectations in the bond market were above 3 percent.

Actual inflation using the Fed’s preferred measure has remained below its 2 percent target for 27 consecutive months.

The Fed “would be in a hurry to tighten rates, but the inflation prints have been the opposite of anything to worry about,” said Priscilla Hancock, global fixed-income strategist for JPMorgan Asset Management in New York, which manages $1.5 trillion in assets. “The Fed is reminding the market not to fight them. They plan to keep policy accommodative for a very long time. Investors have lost a lot of money betting against the Fed.”

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