Solid inflation data on Friday sparked anxiety that the bounce in consumer prices would strengthen the Federal Reserve’s resolve to tighten monetary policy at a more aggressive pace.
Those fears sent prices for short-dated debt tumbling and yields higher. The 2-year note yield
rose 4.2 basis points to 2.014%, its highest level since September 2008, according to Tradeweb, when the financial crisis still had its grip on markets. Bond prices fall when yields rise.
The move came after a report showed the core consumer price index rose 0.3% in December, above the MarketWatch forecast of 0.2%. Core CPI strips out volatile food and energy prices.
Sensitive to shifting expectations for Fed policy, the 2-year yield has made an uninterrupted ascent since last September after analysts started to circle around the view that the U.S. central bank was intent on driving interest rates up even if inflation remains stubbornly below expectations. The Fed drew the fire of market participants who felt its actions were verging on a policy mistake.
But after Friday’s data, investors said fading talk of a persistent lack of price pressures could give policy makers the confidence to ratchet up their pace of rate hikes. Some senior Fed officials have publicly stated their desire to see even higher interest rates, which can be later lowered to combat a future recession.
Expectations for a quarter-percentage-point hike in March has risen to 87.9%, according to fed fund futures data.
The higher-than-expected CPI reading also affirmed rising investor estimates of inflation expectations measured by Treasury-inflation protected securities, or TIPs. The break-even rate for 10-year TIPS hit 2% last week, the first time since March when President Donald Trump’s pro-growth agenda and a Republican-controlled Congress drove fears inflation would make a comeback.
“The dynamic at work here is that inflation expectations will steepen the curve, but when actual data comes out to support that view, investors immediately expect the Fed to raise rates more aggressively to combat rising inflation,” said Bryce Doty, senior portfolio manager at Sit Investment Associates, referring to the yield curve.
The yield curve is a line plotting yields across maturities. A steeper curve tends to demonstrate expectations for stronger growth and higher inflation.
Elevated short-dated yields may also reflect concerns that burgeoning budget deficits widened by recently passed tax cuts will push the Treasury Department to flog fresh debt. The November refunding announcement showed the federal government preferred to see most of the new issuance come through short-dated maturities.
But with the year just under way, a lack of hard data on how deficits will interact with Treasury issuance may keep bond traders from pricing in the upcoming influx of supply.
“I don’t think you can draw any conclusions from the government budget deficits yet,” said Arnim Holzer, a macro strategist for EAB Investment Group.