'I don't think you should jack up rates into this environment right now,' says head of fixed-income at Aptus Capital Advisors
Treasury Secretary Scott Bessent and Federal Reserve Chairman Kevin Warsh face different challenges when it comes to higher yields and inflation.
There isn't any way to spin Wednesday's hot consumer-price index report as good, especially when looking at the bond market's initial reaction.
That's the view of Brian Rehling, co-head of global fixed-income strategy and digital-asset strategy at Wells Fargo Investment Institute.
After a brief reprieve from selling in the $32 trillion Treasury market over the past week, the bond rout returned on Wednesday after inflation data for September rose more than expected.
The reading reflected increasing prices for services, things like airfares, hotels, truck rentals, and heating and electricity.
As a result, the policy-sensitive 2-year Treasury yield BX:TMUBMUSD02Y surged as high as 4.95% earlier in the session, while the all-important 10-year yield BX:TMUBMUSD10Y jumped to 5.33%, before easing back, according to FactSet.
The problem is that investors worry that more interest-rate hikes by the Federal Reserve are needed to tame inflation, but also about the consequences if the central bank fails to act fast enough.
The climb in Treasury yields increases the cost of borrowing money, which in practice should help lower demand for goods and services, potentially doing some of Fed Chairman Kevin Warsh's work for him to tame inflation. The annual inflation rate from the CPI reading was at 3.7%, well above the Fed's 2% target.
The odds of a Fed rate hike after its Oct. 28 meeting surged to 39.3%, according to the CME Group's FedWatch tool, from 21.6% just before the CPI data was released.
"This just reinforced the fact that the Fed has more work to do," Rehling at Wells Fargo said. Yet if the Fed "drags its feet" and doesn't raise rates as fast, "that's when you could see the 10-year yield hit 5.5%, 5.75% and 6%."
How high will the Fed go?
The Wells Fargo team expects four more Fed rate hikes through the end of 2027, which would bring its policy rate to a range of about 4.75% to 5%. The odds currently favor slightly less total increases through the end of next year, according to the CME FedWatch Tool.
For now, the overall economy looks poised to handle higher yields, in large part because of the artificial-intelligence boom that's coursing through the stock market and economy, with more than $1 trillion in capital expenditures expected annually over the next few years.
Outside of AI, however, things look more worrying.
"I don't think you should jack up rates into this environment right now," said John Luke Tyner, head of fixed-income and a portfolio manager at Aptus Capital Advisors, on Wednesday. "We are on fragile glass with the economy."
While the Fed controls short-term rates, longer-dated yields reflect how bond investors feel about things like inflation risks and economic growth in the not-so-distant future.
For his part, Treasury Secretary Scott Bessent has been trying to keep long-dated yields in check, in part by increasing buybacks of 10-year to 30-year Treasurys through the early November quarterly refunding period. Yields dramatically climbed anyway.
Investors demand higher yields when they are worried, or when a supply glut of bonds creates competition for capital. Higher yields result, pushing up borrowing costs for families, businesses and the federal government.
That matters right now more than ever, with the national debt eclipsing $40 trillion, roughly a third of the government's debt needing refinancing annually and with the U.S. running a roughly $2 trillion budget.
"We just have to get things in check," Tyner said. "Why would I lend the government at 5%, when they are running a 6% deficit?"
It could go a long way if the federal government would start signaling it was trying to run something "closer to a balanced checkbook," he added. "I think the market would give them a great reward."
Wednesday's hot CPI data might have restarted the conversation about three or four "adjustment" Fed rate hikes, said Alex Payne, a Vanguard portfolio manager and head of mortgages, agencies, and volatility, but he doesn't a full hiking cycle looks likely, given recent Fed speeches.
In a positive sign, Payne noted that once the 10-year Treasury yield has hit roughly 5.30%, the market has bounced off that level several times now.
Yet higher rates have impacted housing, with existing home sales at the lowest levels in more than 25 years, he said. "In corporate space, it's really impacted the more levered CCC borrowers," Payne added.
-Joy Wiltermuth
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