Bond Traders Enter Fed Blackout Betting a Hike Won't Quash Rally

  • U.S. 10-year yield is at lowest level of 2017 after jobs data
  • Market pricing still indicates Fed hike seen this month

Treasury Yields Plunged to a New 2017 Low

Before heading into the darkness of the Federal Reserve’s blackout period, bond traders loaded up on Treasuries.

U.S. government debt rallied Friday, driving longer-term yields to the lowest this year, after Labor Department figures showed payrolls and average hourly earnings rose in May by less than estimated. The report came on the heels of data earlier in the week showing the Fed’s preferred inflation gauge slipped further below its 2 percent target.

The benchmark 10-year yield finished the week at 2.16 percent, the lowest close since November, while the 30-year yield also set a year-to-date low. The reaction shows that traders are growing skeptical of additional rate hikes beyond June as they lose confidence that economic growth and inflation will accelerate.

There’s also a tinge of political risk. With former FBI Director James Comey slated to testify before the Senate Intelligence Committee on June 8, investigations into Russia’s meddling in the 2016 elections may be about to escalate.

Yet traders still see a Fed hike in June as almost a certainty. The market is pricing in an 83 percent chance the central bank raises its benchmark rate by a quarter-point, based on the current effective fed funds rate and the forward overnight index swap rate.

For bond traders, it’s shaping up like a Goldilocks situation in terms of the economy: Everything is just right for the Fed to continue to normalize, while not hot enough to trigger major losses in Treasuries, said Lisa Hornby at Schroders and Jim Caron at Morgan Stanley Investment Management. The upshot is that yields may edge even lower.

“If the Fed is going to continue on a path of hiking rates when data is not necessarily eye-popping, it’s going to be hard for back-end rates to go up,” said Caron, a senior portfolio manager whose firm oversees $65 billion in fixed-income. “It supports a position in the belly of the curve,” like five- and 10-year notes, he said.

With the 10-year yield breaking its 200-day moving average, the next target is 2.1 percent, according to Tom di Galoma, managing director of government trading and strategy at Seaport Global Holdings. It’s more likely to touch 2 percent before it reaches 2.5 percent, Kathleen Gaffney at Eaton Vance Corp. and Michael Collins at PGIM Fixed Income said Friday on Bloomberg Television.

The aftermath of the jobs data was seen in a marked flattening of the Treasuries yield curve Friday. The spread between two- and 10-year yields shrank to 87 basis points, the least since October, while the difference between the two- and 30-year maturities collapsed to a nearly nine-month low.

“The two-year Treasury hasn’t moved much, while the belly of the curve is outperforming, which to me signals that the equilibrium rate the Fed thinks about is maybe too high,” said Thanos Bardas, a portfolio manager at Neuberger Berman Group, which oversees $119 billion in fixed income. The median long-run target rate on the Fed’s “dot plot,” which represents policy makers’ projections, is 3 percent.

Bardas said that while the Fed is still primed to hike in June, officials will have a hard time doing so again in September if economic data keep missing the mark. The Citigroup Economic Surprise Index, which measures whether data beat forecasts, fell Friday to the lowest since February 2016.

Others agree. Goldman Sachs Group Inc. strategists pushed back their call for a third 2017 rate hike on Friday, to December from September, saying officials need more clarity on the economic outlook.

The next week probably won’t be all that illuminating. Fed speakers are silent, abiding by their self-imposed blackout period, and there’s not much in the way of critical economic data to alter their outlook.

So, for now, traders may have to get used to the bottom of the 2017 yield range.

Here’s what to watch in the week ahead:

June 5Nonfarm Productivity
Unit Labor Costs
ISM Non-Manufacturing Composite
Factory Orders
Durable Goods Orders
June 6JOLTS Job Openings
June 7MBA Mortgage Applications
Consumer Credit
June 8Initial Jobless Claims
Continuing Claims
Bloomberg Consumer Comfort
June 9Wholesale Inventories and Trade Sales MoM
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