The beginning of 2024 posed significant challenges for bond investors, which were exacerbated on a Friday when strong employment data indicated a healthy job market. This robust job growth conflicted with earlier expectations that the Federal Reserve would lower interest rates within the year. These expectations stemmed from a belief that the Fed would act to counteract economic stress caused by previous rate increases. However, the surprising strength of the employment report, showing the most significant job growth in the US in nearly a year and a reduction in the unemployment rate, altered this outlook dramatically.
In the financial markets, these developments caused a shift in expectations among traders, who began to reassess the likelihood of a Federal Reserve rate cut before September. The adjustment in expectations was a direct response to the strong employment data, which suggested a more robust economy than previously thought. This reassessment impacted the bond market, particularly the Treasury yields, which approached their highest levels for the year.
The benchmark 10-year rate experienced a notable jump, increasing by up to nine basis points to approximately 4.40%. Concurrently, the yield on the two-year Treasury note also reached its highest point of the day. This trend was further influenced by comments from Dallas Fed President Lorie Logan, who indicated that it was premature to consider reducing interest rates, aligning with the views of other central bank officials earlier in the week.
The bond market reacted swiftly to the changing economic landscape, with swap contracts showing a diminished probability of a rate cut by the Federal Reserve in June. This reduced probability stood in contrast to predictions made by major financial institutions such as Goldman Sachs Group Inc. and Citigroup Inc., which had continued to forecast a rate cut in June. The likelihood, as estimated by swap contracts, dropped to around 52%. Looking at the probability of a rate cut in July, it fell below 100%, signaling a significant shift in market sentiment.
For the entire year of 2024, traders priced in approximately 65 basis points of rate cuts, a figure that was notably lower than the 75-basis-point median forecast made by Federal Reserve officials in the previous month. This realignment in market expectations indicated a more cautious stance towards the prospect of rate cuts by the Fed.
The reaction from market analysts to the employment data was quite telling. Peter Tchir, head of macro strategy at Academy Securities Inc., expressed his view that the robust employment figures did not provide the Federal Reserve with a clear reason to cut rates in the near future. He predicted that Treasury yields were set to continue their upward trajectory. Tchir attributed this expected rise in yields not only to the strong employment data but also to the rising oil prices. He speculated that the increasing oil prices, combined with the solid economic data, could push the 10-year Treasury yield to surpass levels of 4.5% to 4.6%, a significant increase from current rates.
Later that day, after 3 p.m. New York time, the bond market exhibited notable movements.
Treasury yields across all maturities had risen by at least six basis points. This increase was especially pronounced in the two-year Treasury yield, which saw a rise of nine basis points. Despite these increases, yields for Treasuries with maturities ranging from five to thirty years remained below the peak levels they had reached earlier in the week. This peak was a response to a combination of factors: strong economic data, rising oil prices, and hawkish comments from other Federal Reserve officials, including Atlanta Fed President Raphael Bostic and Minneapolis Fed President Neel Kashkari. These developments collectively influenced market perceptions and yields.
Despite the overall trend of rising yields, some aspects of the employment report provided a counterbalance. The report included data showing an increase in the labor-force participation rate, which holds the potential to moderate wage pressures. This detail was highlighted by Randall Kroszner, a former Fed governor and current professor at the University of Chicago Booth School, during his appearance on Bloomberg Television. He pointed out that the participation rate had ticked up to 62.7% from 62.5%, surpassing consensus estimates of 62.6%. This uptick in labor-force participation was seen as a positive sign, suggesting a larger pool of potential workers, which could ease the upward pressure on wages.
The implications of the employment data were significant enough to prompt a policy forecast revision at Pacific Investment Management Co. (PIMCO), a major investment management firm. PIMCO's economist, Tiffany Wilding, noted that the firm had adjusted its expectations for Federal Reserve policy action in response to the job creation data and other indicators of strong economic momentum in the US at the year's start. Previously expecting two or three quarter-point rate cuts this year, PIMCO revised its forecast to just two rate cuts. This change in PIMCO's outlook reflects a broader reassessment in the financial sector of the Federal Reserve's likely policy moves in response to the evolving economic landscape.
At the beginning of the year, there was a broad consensus among investors and analysts that the Federal Reserve's series of 11 rate increases over the past two years would not only help in controlling inflation but also lead to economic slowdowns. This belief was rooted in the traditional economic theory that higher interest rates can slow down economic activities by making borrowing more expensive. Based on this, there was an expectation that the Federal Reserve would be compelled to lower rates by at least 1.5 percentage points in 2024 to counteract any potential economic stress.
However, this narrative has been contradicted by recent developments. The anticipated progress in reducing inflation has been slower than expected, and key economic growth indicators have remained strong. Furthermore, the continued influx of investments into stocks and corporate bonds suggests that the market perceives the economy as robust and not in immediate need of stimulative lower interest rates.
Guy LeBas, a chief fixed income strategist at Janney Montgomery Scott, provided his analysis of the situation. He characterized the data as slightly negative for bonds, reasoning that it solidified the likelihood of a later start to rate cuts by the Federal Reserve. In his view, the data also decreased the risk of a recession, which in turn led investors to demand higher rates of return on bonds.
This assessment underlines the complex relationship between economic data, monetary policy expectations, and bond market dynamics. The evolving economic indicators seem to have reassured investors about the strength of the economy, prompting a shift in their investment strategies and expectations for future interest rates.
Before the release of the jobs report, strategists at ING Financial Markets had already indicated that the bond market might experience significant changes. They had warned that the benchmark 10-year Treasury yield could revisit the 4.5% level, a high point not seen since the previous November, before a substantial rally occurred at the end of the year. This prediction was based on their analysis of market trends and economic indicators. In the options market, traders had positioned themselves in anticipation of this movement, with bets suggesting a shift towards nearly 4.5% and generally higher yields overall. These market movements and trader positions reflect the anticipatory nature of financial markets, where expectations about future events often drive current trading behaviors.
Ira Jersey, a market analyst, offered his perspective on the Federal Reserve's potential course of action in light of the data. He stated that it would be difficult for the Fed to justify rate cuts if they were truly basing their decisions on data. Jersey identified the 4.5% level as a crucial technical threshold for the 10-year Treasury yield, suggesting that reaching or surpassing this level could signal a significant shift in market expectations and Fed policy. His comment highlights the importance of key technical levels in financial markets as indicators of broader economic trends and policy responses.
In the following week, Treasury investors were presented with the opportunity to buy three- and 10-year notes and 30-year bonds through government auctions starting on Tuesday. An important factor in these auctions would be whether the heightened yield levels would drive increased demand for these securities. The bond market's health and investor confidence often hinge on the outcomes of such auctions, as they reflect broader market sentiment and the attractiveness of government securities as investments. These auctions were anticipated to reveal whether investors believed that current yield levels were sufficiently attractive relative to the risks and returns associated with other investment options.
The bond market's response to the employment data was also gauged through a monthly survey conducted by BMO Capital Markets. This survey sought to understand investor intentions following the release of the employment data. The results showed that 57% of investors surveyed indicated they would purchase bonds if the jobs data caused yields to rise. This figure was notably higher than the six-month average of 47%, suggesting a shift in investor sentiment towards purchasing bonds at higher yields. Such surveys provide valuable insights into market sentiment and can indicate shifts in investment strategies among market participants.
The upcoming week was also set to bring important economic data that could further impact the bond market, with the release of the March consumer price index (CPI) being particularly noteworthy. The CPI measures inflation and is a key indicator watched by investors and policymakers alike.
The CPI increases for February had been larger than estimated, which had already led to a rise in Treasury yields. Market-based inflation expectations had been rising in tandem with the prices of oil and gasoline futures. Since retail gasoline prices are a significant component of the CPI, their increase could influence the overall inflation reading, potentially impacting bond yields and investor sentiment further as we read in Blommberg.
05.04.2024
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