U.S. Curve Steepens as Traders Test Fed Resolve on Inflation

(Bloomberg) - The U.S. yield curve steepened Monday amid uncertainty over how far the Federal Reserve will need to hike rates to stem inflation running at the fastest pace in 40 years.

The gap between five- and 30-year rates grew to the widest in just over six weeks as long-dated bonds lagged amid the market’s rally. Two-year notes -- the most sensitive to changes in policy -- rallied, with yields falling to 2.62%, an 11-basis-point drop, while 30-year yields slipped 1 basis point to 3.21%. The gains also reflected a flight-to-safety bid as a rout this month in equities continues.

The moves extend the volatile period in government bonds as central banks around the world pare pandemic-era stimulus and came as investors wait for April U.S. consumer-price data due Wednesday. The Fed has raised rates by 75 basis points so far this year and signaled more tightening to come.

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The steepening of the yield curve reflected anxiety about the pace of inflation and speculation about whether the Fed will act aggressively enough to contain it.

On Monday, Federal Reserve Bank of Atlanta President Raphael Bostic said he favors policy makers continuing to raise rates by half-point increments rather than doing anything larger. That echoed Fed Chair Jerome Powell’s assertion last week that three-quarter point moves aren’t currently under consideration.

“If they back down too soon at fighting inflation that market forces will step in and push on the parts that hurt the most,” said George Goncalves, head of U.S. macro strategy at MUFG Securities Americas Inc, pointing to the housing market and other financial assets exposed to rising long-term interest rates.

The yield drop Monday also marks a step back from a steep, swift rise that had caught many traders off-guard. Just over a week ago, a survey by Bloomberg’s Market Live showed 24% of readers thought 10-year yields wouldn’t break above 3.15% this year. They rose to as high as 3.20% on Monday before reversing to trade down about 4 basis points to 3.09%.

“The market still remains in poor shape,” said Christoph Rieger, head of fixed-rate strategy at Commerzbank AG. “It is remarkable that the post-Fed sell-off has actually been driven by long-end real yields. This points towards the market re-assessing the terminal rate that is needed to get inflation under control.”

While Powell last week played down the option of a 75 basis-point rate hike, Richmond Fed President Thomas Barkin said in an interview on Friday that nothing was off the table.

“The market appeared to start coming around to our view that the Fed has much more tightening to do,” Deutsche Bank strategists including Jim Reid wrote wrote in a note, commenting on last week’s moves.

Traders are fully pricing further half-point hikes at the Fed’s next two decisions, with around 200 basis points of tightening seen between now and the end of the year.

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A slowdow in inflation could provide a ray of hope for markets and help them stabilize, Commerzbank’s Rieger added. The Consumer Price Index is expected to rise an annual 8.1% in April, compared to 8.5% in March, according to the median estimate in a Bloomberg survey.

“For the first time in a long time, bonds are beginning to look reasonably attractive from a longer term perspective,” said Dan Ivascyn, the chief investment officer at Pacific Investment Management Co.

European Rout

European government bonds were under pressure earlier in the day, with Italian debt underperforming. European Central Bank Governing Council member Olli Rehn said policy markers should start raising rates in July to prevent inflation expectations becoming de-anchored.

The yield on 10-year Italian government bonds rose as much as 10 basis points to 3.23%. The spread over the equivalent German bond widened to as much as 207 basis points, after breaching a key level last week.

“We have already suggested that the combination of a growth slow-down into which the ECB will hike, and the reduction in liquidity provision will have -- potentially severe -- negative repercussions for spread markets,” Peter Schaffrik, global macro strategist at RBC Capital Markets, wrote in a note.

He expects sovereign and credit spreads to widen further, with the spread on 10-year Italian and German bonds widening to around 250 basis points.

(Updates rates throughout.)

By Alice Gledhill and Greg Ritchie


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