(Bloomberg View) -- The divide between the Federal Reserve and the bond market is getting wider by the day. Policy makers discount the recent weakening trend in inflation as fleeting, expecting the tight labor market will soon unleash animal spirits among consumers in the form of spending. “It’s important not to overreact to a few readings, and data on inflation can be noisy,” Fed Chair Janet Yellen told reporters yesterday after the central bank boosted interest rates.
Bond traders say not so fast. The big rally in the fixed-income markets that has pushed yields on 10-year Treasury notes all the way down to as low as 2.10 percent on Wednesday from 2.63 percent in March suggests traders believe the slowdown in inflation is more than transitory, overwhelming the Fed’s confidence in stronger growth and labor markets. It’s as if the market is trying to force the central bank to back off its hawkish stance. The consumer price index data earlier in the day was particularly meaningful for traders, as the core reading came in 0.1 percentage point below forecasts, the third miss in a row for that crucial data series. The retail sales data released at the same time was also shockingly weak.
While short-term yields are forced to react to the Fed’s hawkish biases, the current levels of long-term yields suggest traders have all but erased any remaining cushion for further tightening in 2017. And they show complete disregard for the Fed’s plans to hike in 2018 and 2019. That can be seen in the rapidly shrinking gap between two- and 10-year Treasury note yields.
But now there isn’t much likely to change in the market for quite some time. Short-term Treasuries trade at a very narrow spread over funding costs, with the two-year Treasury note yielding about 1.35 percent while Treasury collateral finances are near 1.20 percent. This shrinkage of positive carry acts as a brake on further drops in short-term note yields. That brake is much weaker, however, in longer maturities, suggesting further yield curve compression in market rallies.
Treasury market volatility was already hitting multiyear lows before the weak data shocks. And since the market has removed virtually all insurance for further rate hikes, it makes sense that volatility could fall further as the Treasury market anticipates no further shifts in the federal funds rate from the Fed for an extended period.
Treasuries had been consolidating for several weeks around the 200-day moving average of 2.19 percent for 10-year yields, just above the year-to-date low of 2.13 percent of last week. The break of those important technical levels will keep the chart-oriented market players in the same bullish mood they have been in since March. Individual investors have been piling into fixed-income mutual funds as well, adding $8.1 billion in the week ended June 7, according to ICI. With expectations for further Fed action anytime soon fading, Treasuries could quickly find some equilibrium, leaving traders and investors struggling to adjust to much smaller market moves.
Perhaps they can attend next year’s International Interdisciplinary Boredom Conference. This year’s version in Warsaw included talks on breakfast toast, sneezing, postmodern boredom and vending machine sound, all of which could be more interesting than the bond market this summer.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Scott Dorf is a managing director at Amherst Pierpont Securities. He has been selling and trading U.S. Treasuries for more than 30 years.
To contact the author of this story: Scott Dorf at sdorf7@bloomberg.net.
To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.
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