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Treasury rout bolsters view that Fed will call time on rate rises

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A surge in US borrowing costs has bolstered investors’ conviction that the Federal Reserve is finished raising interest rates, after months of aggressively increasing them in a historic battle against inflation.

Yields on Treasury bonds reached the highest points in more than a decade this week, raising financing costs for businesses and consumers that could slow down the economy and tamp down prices without further action from US central bank.

The latest top official to back this view was Mary Daly, president of the San Francisco Fed, who on Thursday said the central bank does not need to “rush to any decisions” about interest rates at a time when the labour market is showing signs of cooling, price pressures have abated and Treasury yields have sharply risen.

“If financial conditions, which have tightened considerably in the past 90 days, remain tight, the need for us to take further action is diminished,” she said in prepared remarks.

Daly, who is not a voting member of the rate-setting Federal Open Market Committee until next year, added: “If we continue to see a cooling labour market and inflation heading back to our target, we can hold interest rates steady and let the effects of policy continue to work.”

She made her comments a day before the release of a US monthly payrolls report that is expected to show a modest slowdown in hiring. A Goldman Sachs index of financial conditions, which measures companies’ costs of borrowing money, has hit the highest level in a year.

The benchmark 10-year Treasury yield this week touched levels last seen in August 2007, at 4.9 per cent. The 30-year Treasury yield also notched a roughly 16-year high, rising above 5 per cent. On Thursday yields eased from those peaks.

Bond yields rise when prices fall. Yields on Treasuries climbed following a market rout that gathered momentum after Fed officials last month embraced a “higher for longer” approach to setting interest rates, indicating support for one more quarter-point rate rise and slashing the expected magnitude of rate cuts over the next two years.

However, investors now view no new rises as a more likely outcome. Futures markets point to roughly 30 per cent odds of a quarter-point increase by December, down from 40 per cent last Friday and more than 50 per cent two weeks ago.

“The bond market heard them loud and clear about ‘higher for longer’ and effectively tightened for them,” said Priya Misra, a portfolio manager at JPMorgan Asset Management. “The aim of monetary policy is to tighten financial conditions, and they just got [that] this last week.”

This has offset the need for a further rate rise this year, Misra said, suggesting that with the federal funds rate at a 22-year high of 5.25 per cent to 5.5 per cent, the central bank had squeezed the economy sufficiently to get price pressures firmly under control.

The recent rise in Treasury yields “means the Fed needs to do less”, added Mike Cudzil, a senior bond portfolio manager at Pimco.

Line chart of Goldman Sachs financial conditions index showing The bond sell-off has tightened financial conditions

While traders are not betting the Fed will raise rates again, they have lowered expectations of how generous the central bank will be with any rate cuts next year. They expect the policy rate to fall to 4.5 per cent to 4.75 per cent by the end of 2024, implying roughly three quarter-point reductions from the current levels. At the start of September, those traders expected at least one more cut than that.

Other Fed officials have also taken stock of the recent market gyrations. Loretta Mester, the hawkish president of the Cleveland Fed, told reporters this week that the move in Treasury yields was “certainly going to feed into” decisions about whether another rate rise is necessary this year.

While at this point she sees scope for an increase at the upcoming meeting that ends on November 1, that is predicated on the economy evolving as expected.

Michelle Bowman, another hawkish governor, made clear this week that monetary policy is not on a “preset course”. While she also believes the Fed is not yet done damping demand, Bowman said she would support another rate rise “at a future meeting if the incoming data indicates that progress on inflation has stalled or is too slow to bring inflation to 2 per cent” — the Fed’s longstanding target — “in a timely way”.

Line chart of Daily high yield (%) showing The 10-year Treasury yield has reached 16-year highs

Andrew Hollenhorst, chief US economist at Citigroup, argued the data would remain strong enough to warrant raising rates again next month, noting that on the whole growth has been robust, the labour market — while cooling — is still tight and prices pressures remain.

“They want to make sure there is enough restraint to slow things down and cool things off,” he said. “I don’t think the level of 10-year Treasury yields would be concerning for them here.”

The sell-off in bonds is happening as the US Treasury has increased borrowing in recent months to cover widening budget deficits and make up for lower tax revenue, boosting supply.

“If [yields] continue to rise at the rapid pace we’ve seen, then the likelihood of something breaking and some dysfunction happening is increasing,” said Marc Giannoni, chief US economist at Barclays, who formerly worked at the Fed’s regional banks in Dallas and New York. That could deter further action from the central bank, he said, although for now he still expects the Fed to raise interest rates one more time this year.

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