Treasury Yields Test Downtrend With Inflation Genie ‘Out Of The Bottle’

Investor angst remained palpable Tuesday, as bonds threatened to extend losses on persistent inflation fears and ever-present policy jitters, before ultimately rallying after core CPI came in cooler than expected.

10-year US yields were still near the highest since 2018, and markets remain obsessed with a breach of the four-decade downtrend. A close above ~2.83% would make it official.

At various intervals over the past couple of weeks, I’ve been tempted to suggest this is mere trivia — what counts is the bond drawdown and the implied losses, not some trend line. I’ve refrained. My pen is acerbic enough without willfully belittling something quite a few people seem to think is very important. Mercifully, someone else made the point on Tuesday, sparing me the trouble.

“Of course if you’re an investor in Treasurys, you don’t care what the purists think,” Bloomberg’s Cormac Mullen wrote, referencing the orange line in the figure (below). “You’re more concerned with managing the worst losses in decades this year.”

Mullen is correct. What matters here isn’t whether the breach of a line gives analysts carte blanche to write the bond bull’s obituary. What counts (figuratively and literally) is that, on Bloomberg’s TR index, Treasurys are down nearly 8%, an egregious rout that has no modern precedent.

That has implications for everything, everywhere. This is, after all, the risk-free rate we’re talking about. Everything is priced off of it. And the assumed negative correlation with stock returns that serves as the bedrock of balanced portfolios is undergoing its first serious test since the onset of the “have your cake and eat it too” regime (i.e., two assets which rally together over time but which nevertheless remain negatively correlated over multiple windows) more than two decades ago.

There’s virtually no agreement on where things go from here. As Mullen went on to say Tuesday, 3% is “the whisper target for many investors now,” and it certainly seems achievable in the near-term — 20s are already there. Someone who spoke to Bloomberg for a Tuesday article said 10s are destined to test 3.5%. “The Fed’s been slow in recognizing that inflation is coming,” he said, noting that the market has also been reluctant to admit the inflation genie is “truly out of the bottle.” Now, “we’re all catching up,” he went on to suggest.

But a 3-handle may be difficult to hold because i) dip-buyers will show up eventually, especially in the event some new escalation in Ukraine (think: Chemical weapons) prompts a flight to safety and ii) the Fed is now very likely, in my judgment, to inflict enough damage on the economy to cap long-end yields.

“The extension of the selloff in Treasurys that brought 10-year yields as high as 2.832% and 30s to 2.856% was at least partially a reflection of the highest YoY read on core consumer prices since August 1982 as well as a setup for [Tuesday’s] 10-year offering and [Wednesday’s] long-bond supply,” BMO’s Ben Jeffery and Ian Lyngen wrote on Tuesday morning, prior to the CPI data. “It remains to be seen whether the passage of the event risks will mark the near-term yield highs as investors look to the take advantage of 10s at levels not seen since late 2018, or if there is greater bearish conviction to stage a challenge of 3%,” they added, noting that they’re “biased toward the former given the scale of the repricing but continue to prefer taking advantage of the steepening we’ve seen to reenter flattener positions.”

By the end of Tuesday’s session, the curve was sharply steeper. The 10-year sale tailed, while 2s and 5s richened dramatically. The main question remains whether the Fed’s efforts to rein in inflation will end in tears for the economy.

On Monday, Christopher Waller admitted that “collateral damage” is a distinct possibility considering the necessity of using what he described as “a brute-force tool” to tamp down inflation. Waller called rate hikes a “hammer.”

It was an apt characterization. For the better part of a year, economists have debated whether the Fed has the appropriate tools to address price pressures driven primarily by supply shocks. A little bit of demand destruction won’t do the trick when inflation is running 8%.

If you can’t address the root cause of the problem (in this case supply chains and various shortages), you’re left to bludgeon prices into submission by engineering a recession or, as Waller put it, by acquiescing to the likelihood of “collateral damage.” As the old adage goes, “If all you have is a hammer, everything looks like a nail.”