Investors increasingly expect US Treasury yields to stay high for an extended period as persistent inflation and rising oil prices linked to Middle East tensions heighten overall economic price pressures.
Long-term Treasury yields, especially the benchmark 10-year note, have jumped as investors seek higher returns to offset inflation risks.
Higher yields immediately raise borrowing costs in mortgages, corporate bonds, and leveraged loans.
Oil prices are driving Treasury market moves.
Market participants are increasingly viewing oil prices as the key driver behind rising yields and concerns about inflation.
The surge in energy prices has prompted several investors to reduce exposure to long-duration bonds.
Since the beginning of March, the 10-year Treasury yield has climbed by roughly 45 basis points and reached an 11-month high on Wednesday.
It was last trading at 4.484%.
Higher benchmark yields could also create challenges for US equities as companies and consumers face increased borrowing costs.
Elevated financing expenses can slow economic activity, pressure corporate profits, and make bonds more attractive relative to stocks.
Warsh faces inflation challenge
Investors believe incoming Federal Reserve Chair Kevin Warsh could face significant challenges if inflation remains stubbornly high.
“If the first things we hear from him (Warsh) are dovish arguments about how the Fed can cut interest rates, I think that’s going to be a big problem for the bond market,” said Ryan Swift, chief US bond strategist at BCA Research in Montreal, as cited in a Reuters report.
Swift warned that premature discussions around rate cuts could lead to inflation expectations becoming unanchored.
Despite inflation concerns, US equity markets remained resilient on Wednesday, with the S&P 500 and the Nasdaq advancing on gains in artificial intelligence-linked technology stocks.
Financial markets currently expect the Federal Reserve to keep its policy rate target unchanged at 3.5%-3.75% this year.
Investors anticipate steeper yield curve
Several investors expect the Treasury yield curve to steepen further as inflation pressures remain elevated.
The spread between 10-year and two-year Treasury yields was last at 48.50 basis points after steepening during the past two sessions.
Chip Hughey, managing director of fixed income at Truist Wealth in Richmond, Virginia, said sticky inflation reinforces expectations that the Federal Reserve will likely keep rates unchanged until price pressures ease.
Hughey said he expects the curve to steepen further if the Fed eventually begins cutting rates later in the year.
Such a move could lower short-term yields while longer-dated yields remain elevated because of persistent inflation and economic resilience.
Fed balance sheet policy in focus
Investors are also closely watching Warsh’s longer-term views on the Federal Reserve’s balance sheet.
Warsh’s preference for shrinking the Fed’s balance sheet and potentially shortening the maturity profile of its portfolio could affect Treasury supply dynamics and term premiums.
A smaller Fed balance sheet would reduce government demand for Treasuries and tighten financial conditions by withdrawing liquidity from markets.
Reduced Fed bond purchases would also increase Treasury supply available to investors, a development that could pressure bond prices and lift long-dated yields further.
Martin Tobias, US rates strategist at Morgan Stanley, said investors are still trying to assess how Warsh may approach balance sheet policy.
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