Mauled Treasuries To Get Some Respite, Fed Priced-In

Authored by Ven Ram, currency & rates strategist at Bloomberg,

As brutal as the bond-market backdrop has been, losses in Treasuries may abate in the second quarter even as the Federal Reserve takes aim at quelling inflation that is running at a breakneck pace.

The odds of a repeat of the first-quarter selloff are approximately 1-in-30,000…

The Bloomberg Treasury Index incurred a loss of 5.91% since the start of the year through Tuesday, the worst in data going back nearly 50 years.

That represented a 2.5 standard-deviation move to the left — in itself an extreme probability in a normal distribution of returns that is confirmed by running the Kolmogorov-Smirnov test.

Fundamentals also suggest that losses may moderate.

Two-year yields surged about 160 basis points this quarter, the most since 1984. That increase came on top of a 46-basis point move in the last quarter of 2021, suggesting the market has priced in the bulk of the Fed’s likely tightening.

The possibility of a de-escalation of conflict in Ukraine sent breakeven rates lower across the curve, with the markets heaving a sigh of relief on what that would mean for inflation.

The inversion of the two- and 10-year part of the yield curve may also alter investor behavior.

While there are more authentic markers of a true curve inversion, the negative spread may become a self-fulfilling prophecy: if economic agents in sufficient number believe a slowdown is in the offing and modify their decisions accordingly, we could get a veritable speed-bump.

Notice how the curve inverted well after news of Ukraine broke on Tuesday, suggesting that there is already a bid to mop up the yields currently available on the longer maturity.

That is classic investor behavior ahead of typical slowdowns.

The confluence of the de-escalation of conflict and fears of a slowdown — whether well-founded or otherwise — may therefore offer a tactical long bias for bonds.

While Fed speakers including Chair Jerome Powell have remarked that they are open to raising rates by 50 basis points if need be, they have stopped short of suggesting that such a scenario would be their base case.

Even though headline inflation is already running around 8%, the Fed seems reluctant to deploy outsized increases for fearing of creating an adverse feedback loop in the economy.

What could go wrong with this outlook?

Possibly, double-digit inflation. A monster print of that magnitude may force the Fed to raise rates by 50 basis points in May and keep volatility on the front burner.

That scenario apart, the current backdrop of markets having priced in an aggressive Fed trajectory and a possible de-escalation in Ukraine hostilities taken together suggests that the denouement for Treasuries may be less sordid in the months ahead.