Fed struggles to contain bond rout as investors bank on recovery

A global bond retreat resumed on Thursday despite Fed chair Jay Powell’s insistence that the US central bank has no plans to wind down its bond-buying efforts any time soon, with many investors betting yields will top their March highs in the coming months as prices fall.

The Federal Reserve chief sparked a brief rally on Wednesday when he said it was too soon to talk about “tapering” the central bank’s purchases, capping a period of relative calm in bond markets since it last plunged in February and early March.

But US Treasuries swiftly gave up their price gains on Thursday, pulling down European bonds in their wake. Some fund managers pointed to the fleeting price increases as a sign that the Fed will struggle to contain a further rise in Treasury yields as the economy booms in the coming months.

Michael Kelly, head of multi-asset investment at PineBridge Investments, said he expects the 10-year Treasury yield — a benchmark for borrowing costs around the world — to rise “not due to expectations of tapering pulling forward, but the brute force of the economy rising”. If the Fed is unsuccessful at beating back market expectations, yields would be heading towards 2 per cent, rather than the current level of 1.658 per cent, he added.

The latest bout of selling came as data on Thursday showed the US economy grew at an annualised rate of 6.4 per cent in the first quarter, beating economists’ expectations. As more Americans are vaccinated against Covid-19 and restrictions lift, many investors expect an acceleration in growth and rising inflation — dimming the appeal of safe assets such as government bonds. According to forecasts compiled by Bloomberg, analysts also expect the benchmark bond to trade closer to 2 per cent by the end of the year.

Despite the vigorous recovery, Powell made it clear there are no plans to dial back the Fed’s $120bn monthly asset purchase programme. 

“No, it is not time yet,” he said at Wednesday’s press conference. “Economic activity and hiring have just recently picked up after slowing over the winter, and it will take some time before we see substantial further progress.”

However, some investors have a more hawkish view on the future path of policy than Fed officials. “The pressure will start to build around the June meeting for tapering talk,” said Noelle Corum, a portfolio manager at Invesco. 

The Fed’s most recent forecasts, published in March, indicate the central bank plans to keep interest rates tethered close to zero until at least 2024. But eurodollar futures, a widely watched measure of market interest rate expectations, currently point to a lift-off by early 2023, with at least two more increases expected by March the following year.

That conflict is likely to result in the market “testing” the Fed’s resolve by early summer, according to Mohammed Kazmi, a portfolio manager at Union Bancaire Privée.

“They have been able to push through this last meeting because we are still in the early stages of this vaccine-led recovery,” he said. “By June you will probably have seen two more very strong jobs reports. It’ll get harder and harder to explain that away.”

Other investors argue the aggressive pricing of rate increases is a sign markets are getting ahead of themselves. Mike Riddell, a portfolio manager at Allianz Global Investors, agrees with Powell’s assessment that inflationary pressures are likely to be temporary, and growth is likely to return to its underwhelming pre-Covid path once the initial rebound has passed.

“To expect another big sell-off, you would have to believe we are going into a higher growth environment than we have seen in the last decade,” Riddell said. “But demographics have worsened and debt levels are higher. I can’t see why growth would be going supersonic.”

The Treasury market may also face pressure from abroad. While the US led the February global retreat from bonds, the euro area weathered the storm relatively well. Now that Europe’s relatively sluggish vaccine rollouts are gathering pace, however, some fund managers believe European yields could bear the brunt of the next wave of selling. German yields rose to minus 0.18 on Thursday, the highest level since early 2020.

Kazmi has been selling longer-dated German bonds, betting that yields could be headed back above zero later in the year. “The rates markets is global,” he said. “Even if it’s Europe that leads the way this time, the US won’t be far behind.”