Front-End Yields Threaten To Boil Over

By Ven Ram, Bloomberg Markets Live commentator and analyst

The recent renewed selling pressure in front-end Treasuries is set to continue in the coming months, likely sending two-year yields to around 4% for the first time since the global financial crisis.

Treasuries got a kick in the teeth after headline inflation in the US surged to 8.6% in May, the highest in decades, putting paid to the popular theory that price pressures might already have peaked.

That upsurge means that overnight indexed swaps, which were factoring in about 180-200 basis points of tightening from the Federal Reserve in the remainder of the year before the data, are now pricing around 280 basis points.

With the Wall Street Journal — often seen as a conduit for Fed messaging — suggesting the central bank is likely to raise its benchmark by 75 basis points on Wednesday, the swap-market pricing essentially means that traders are estimating a move of about 50 basis points each time the Fed meets in the remainder of the year.

Given that a terminal rate of around 3.95% is priced in, two-year Treasuries have met with renewed volatility, calling for an update of the earlier outlook that was predicated on cumulative hikes of 250 basis points for both this year and next based on the Fed’s then-prevalent guidance and dot plot.

If the latest market calculus proves accurate, two-year Treasuries — which seem to have won a reprieve on Wednesday ahead of the Fed meeting — face further downside, pushing yields higher in the coming months.

The Fed’s revised guidance this week is likely to show a dramatic shift in the median dot plot for this year, which currently stands at just 1.875%.

The estimate for the two- year yield isn’t a target but a continually evolving update that is extremely sensitive to incoming inflation data and the consequent re-pricing of expectations on the quantum of Fed tightening.

Former Treasury Secretary Lawrence Summers, who warned last year that inflation wasn’t as transitory as the Fed believed, now says that major components of the inflation index could accelerate in the months ahead. Any further upsurge in inflation toward, say, 9% may force the Fed to persist with tightening for even longer, posing an additional upside risk to two-year yields.

To be sure, front-end Treasuries could yet earn a reprieve should the uptick in May inflation prove to be a one- off, and further incoming data print softer. That would ease the burden on the Fed and possibly cause it to raise rates at a slower pace.

All told, the inflation surprise for May has upended the market calculus on Fed pricing and opened up further downside for Treasury yields, especially at the front end.