US Treasury bonds are set to close June with a modest gain, breaking a lackluster streak from the first five months of the year, as inflation expectations have eased.
As longer-term yields declined, the Bloomberg US Treasury Index rose 0.7% in June through Monday. The index had been flat year-to-date through the end of May, when surging oil prices driven by conflict pushed up actual and expected inflation. The oil rally also led traders to abandon bets on Federal Reserve rate cuts and instead price in hikes. Benchmark yields reached their highest levels of the year in May.
This pressure has eased somewhat as oil prices retreated in June to levels last seen in late February, before the conflict escalated. Meanwhile, expectations for at least one Fed rate hike in the second half of the year have grown, further dampening inflation expectations. This has pushed short-term yields higher, offsetting the boost to overall market returns from the 30-year yield falling to its lowest level since March.
The interest rate market experienced a turbulent second quarter. The Fed's policymakers, meeting in June for the first time under Chair Kevin Warsh's leadership, projected a focus on price stability. This reinforced the rate-hike expectations that emerged during the Iran conflict, though we saw some easing of these concerns by quarter-end as oil prices collapsed, but the underlying worries persist.
The Federal Open Market Committee's quarterly projections showed an increase in the number of officials supporting rate hikes to combat high inflation. Furthermore, Chair Warsh's vow that the Fed will restore price stability has alleviated concerns that he might yield to political pressure to cut rates.
Also in June, investors increasingly embraced the view that the US economy might need higher interest rates to curb inflation regardless of oil prices, partly due to capital expenditure on AI infrastructure. Stronger-than-expected May jobs data released on June 5 triggered the month's most severe sell-off. The upcoming June jobs report, due Thursday, could prompt traders to renew bets on a Fed hike at its next policy meeting on July 29.
The Fed aims to maintain inflation around 2% over the long term. Its preferred inflation gauge, the Personal Consumption Expenditures Price Index, has been above that level since early 2021, standing at 4.1% in May.
Supplementary jobs data released Tuesday, the May JOLTS job openings figure, came in above expectations, putting pressure on Treasuries. ADP Research is scheduled to release its private-sector employment indicator on Wednesday. US markets will be closed Friday for the Independence Day holiday.
Following the Fed's hawkish shift on June 17, the two-year Treasury yield peaked at 4.23% on June 22, its highest level this year. It ended June around 4.14%, still up more than 13 basis points for the month. The 30-year yield fell about 8 basis points to 4.89% and touched 4.82% last week, its lowest since March.
The theme of the past three months has been trying to separate the signal from the noise. The noise involves the impact of the Iran conflict, how AI capital expenditure is funded and whether it is being monetized, and the change in Fed leadership.
It is anticipated that economic data will have a greater impact on price action in the third quarter. While a July rate hike seems unlikely, the outcome of the September meeting will depend on evidence of whether oil price effects on inflation are spilling over into broader inflation measures and whether the labor market is re-accelerating.
J.P. Morgan's rate strategists noted last week that the 10-year Treasury yield, near 4.37% on Tuesday, is undervalued by about 25 basis points, as the June jobs data could lower the threshold for the market to price in expectations of further Fed tightening.
However, they advised against establishing short positions before Wednesday, as yields tend to fall toward quarter-end when stocks have outperformed bonds by a significant margin. The S&P 500 index rose more than 14% in the second quarter.
Given the relative performance of stocks versus fixed income, rebalancing flows have been particularly noteworthy in the second quarter.
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