Another round of lackluster inflation data on Tuesday helped affirm suspicions that the Federal Reserve is now a peripheral player in the bond market.
Expectations for shifts in U.S. central bank policy usually dictate where Treasury yields are headed. But market participants say the combination of muted price pressures and the Fed’s decision to stay patient on further rate moves mean other factors such as how the global economy performs will decide whether Treasurys will break out of their current trading range.
“Near-term inflation does appear relatively contained on a headline basis. And because of how the Fed’s reaction function has changed, you would need a pretty sizable jump in inflation to make the Fed move,” said Eddy Vataru, portfolio manager at Osterweis Capital Management, in an interview with MarketWatch.
Core CPI pushes the Fed further into the background. Now USTs are all about flows and event risks
— Ed Bradford (@Fullcarry) March 12, 2019
The 10-year Treasury note yield TMUBMUSD10Y, -1.19% has been stuck between 2.60% and 2.80% since the beginning of the year. The benchmark yield fell after the latest consumer prices report, leaving it down a basis point to trade around 2.63%, Tradeweb data show.
The latest February inflation reading showed the core gauge for consumer prices stripping out for food and energy had only risen 0.1%, though it rose 0.2% on a broader basis. Slow inflation growth can limit the corrosive influence of price pressures on bond’s fixed-interest payments and diminish the possibility of rate increases.
Without having to worry about inflation and an aggressive Fed, investors have steadily moved into bonds. Mutual funds specializing in fixed-income assets have attracted around $76 billion in the year-to-date period through March 6, even as equity funds have seen outflows of around $26 billion, EPFR data show.
“There just a lot of anecdotal demand from cash to Treasurys,” said Jason Thomas, chief economist at AssetMark.
Since the January meeting, the central bank has urged a more patient stance on the path for interest rates, drawing speculation that the Fed is unlikely to try to suppress inflation if it touches, or even exceeds, its 2% target. Fed Chairman Jerome Powell hinted last week in front of Congress that he was willing to allow inflation to temporarily overshoot its goal, enabling prices not just to reach 2% in better economic times but to average around that level.
“This Fed is willing to now let inflation, and inflationary expectations, move above its long-term target, as there is a need to see inflationary expectations move higher from here, while the near-term data suggests that prices are likely to move in the other direction, with decelerating inflation prints through mid-year,” wrote Rick Rieder, chief investment officer of global fixed income for BlackRock.
As a result, the bond market is anticipating the Fed’s next move will be a cut to interest rates, not a hike, said Vataru.
The 5-year note yield TMUBMUSD05Y, -1.17% is currently trading below the upper bound of the Fed’s benchmark interest rate, reflecting expectations for a fall in rates. The yield for the intermediate maturity stands at 2.43% compared with the upper range of the fed funds rate between 2.25% and 2.50%.
“Chair Powell will be dovish over nearly the entire year of 2019,” said John Herrmann, director of rates strategy at MUFG Securities, in emailed comments.
With the central bank on hold and the risk of a flare-up in prices muted, investors say long-term bond yields are unlikely to escape their current trading range without an outside catalyst such as a broader improvement in the global economy.
That was highlighted after global growth concerns pushed the European Central Bank to delay the timing for its next rate hike last week, pushing German debt yields TMBMKDE-10Y, -18.63% lower. This prevented the 10-year Treasury yield’s from rising further, pulling it back from a recent high of 2.75%.
Still investors urge caution as inflation tends to be backward-looking. If price pressures stir again as the economy extends its expansion, market participants who dived into longer-maturity bonds may run into a nasty surprise.
“Inflation has stalled for now. But investors should be vigilant,” said Vataru.
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