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The strength of the U.S. economy and the specter of persistent price pressures have fueled a sharp surge in borrowing costs on both sides of the Atlantic as investors rethink the trajectory of global interest rates.
The global bond sell-off pushed benchmark U.S. 10-year yields near their highest since 2007 this week, while equivalent UK gilt yields hit their highest since 2008 and French 10-year yields hit their highest since 2012 level.
Yields rose after a series of data showed that the U.S. economy may be stronger than previously thought and that inflation may now take longer to moderate. That has prompted investors to delay expectations of when the central bank will be able to start cutting rates.
The Fed even warned of “significant upside risks to inflation” in minutes of its meeting released Wednesday, though some officials appeared skeptical about the need for further rate hikes.
The moves have trapped some investors who thought interest rates had peaked and returned to the bond market to lock in the yield on offer.
“The narrative heading into the summer holidays was focused on the next big move being lower interest rates, but the market seems to have been caught off guard on that front,” said Pete Haynes Christiansen, head of fixed income research at Danske Bank.
“Yields are rising everywhere,” said Andrés Sanchez-Balcazar, global head of bonds at Pictet Asset Management. “Investors have been selling bonds lately, believing that there will be an increase due to a tight labor market and sticky core inflation. , the central bank will not consider cutting interest rates.”
Despite Friday’s drop, benchmark U.S. Treasury yields were still around 4.23%, 0.27 percentage points higher than at the start of the month. UK 10-year bond yields rose 0.38 percentage points over the same period, while German bund yields, considered the European benchmark, rose 0.15 percentage points to 2.62%.
Ed Al-Hussainy, senior analyst at Columbia Threadneedle, said a surge in government bond supply was driving the surge in yields. “When you combine fundamentals and technicals like in this case, it overwhelms everything.”
The U.S. Treasury Department announced last month that it expects to issue bonds worth $1 trillion net in the three months from July to September to make up for falling tax revenues.
Demand from some foreign investors may wane as issuance grows. The value of government debt held by Japan and China, the two largest holders of US debt, fell 11% and 12%, respectively, in the year to June, US Treasury data show.
James Athey, investment director at Abrdn, noted that Japan’s move last month to loosen yield curve control “is likely to encourage Japanese investors to reduce their global holdings in favor of domestic bonds,” which could continue to put upward pressure on Japanese bonds. Yields on U.S. and European debt.
Investors also said lower trading volumes this month have led to wild swings in bond prices as many traders are away on vacation.
“There’s a lot of volatility in the market right now because the liquidity is so bad,” said Mike Riddle, bond portfolio manager at Allianz Global Investors. “Most U.S. data have unexpectedly risen over the past six weeks, and that has had a huge impact on bond prices. Influence.”
U.S. retail sales data came in significantly better than expected this week, rising 0.7% in July, while the Philadelphia Fed’s August manufacturing business outlook survey soared to its highest level since April 2022.
“With the third straight quarter of economic growth expected to be around 2%, it is unclear why inflationary pressures will dissipate,” economists at Citigroup said.
They warned that it may take “a sustained rise in 10-year Treasury yields to slow economic growth, particularly in the housing sector, and return to the 2% inflation target”.
While U.S. core inflation — which strips out volatile food and energy prices — has fallen to 4.7 percent in recent months, it remains well above the Fed’s target. The UK is still grappling with persistent sticky price pressures, with core inflation at 6.8%, compared with 5.5% in the euro area. Commodity prices rose across the continent, pushing inflation expectations to a decade high.
The labor market also remains tight, with U.S. average hourly earnings rising 4.4% in July from a year earlier. In the UK, official data this week showed annual wages rose by 7.3%, the largest increase on record.
“Wage pressures are everywhere and they’re putting pressure on employers to charge more – that’s not conducive to a quick return to target inflation,” said Robert Tipp, global head of fixed income bonds at PGIM.
He expects “the center of gravity for long-term yields to stabilize at 4%” over the next one to three years. “The market view right now is that the neutral fed funds rate is 2.5% and the Fed will eventually return to that level, but I really doubt that,” he said.
Central banks on both sides of the Atlantic insisted they would continue to base their data on future rate decisions.
Economists at Evercore said the recent surge in yields “represents a serious tightening in financial conditions,” which in turn could help the Fed rein in inflationary pressures. This would help “offset growth surprises from the inflation outlook,” they concluded.
Traders are now betting the federal funds rate will stay close to its current target rate of 5.25-5.5 percent until the middle of next year, with the European Central Bank raising rates by another quarter of a percentage point by the end of the year. It raised interest rates to 4% this year, while the Bank of England’s rate will peak at 6% early next year.
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