US Treasuries were on track for their best week in a year heading to New York on Friday afternoon, as investors shrugged off the highest inflation since 2008 as government debt piled up.
The benchmark 10-year Treasury yield fell 0.09 percentage points to 1.47 percent, marking its biggest weekly drop since June of last year.
The move was prompted by declining inflation expectations. The 10-year flat rate inflation rate fell 0.08 percentage points to 2.36 percent this week.
The slowdown in long-term inflation expectations occurred despite data released on Thursday which showed the annual increase in US consumer prices jumped to 5 per cent in June.
That points to a growing willingness among investors to accept the Fed’s mantra that high inflation will prove transient, stabilizing once comparisons with last year’s closed economy are over.
The 10-year Treasury yield fell 0.06 percentage points on Thursday, before rebounding 0.03 percentage points on Friday.
There has been a sharp turnaround in the world’s largest government bond market over the past month. Ten-year inflation expectations hit their highest level since 2013 in early May, and the ten-year Treasury yielded 1.70 percent at that point. Many fund managers have been betting that the Fed will have to respond to the inflation boom by cutting back on monetary stimulus soon, curtailing purchases of Treasurys and government-backed mortgages that currently stand at $120 billion per month.
“Last month, people have been looking at rising inflation and thinking that central banks can’t stand by and do nothing,” said Andrea Ianelli, investment director at Fidelity International. “But investors are waking up to the fact that that’s exactly what they’re going to do. “
Analysts say the recent rally was driven by short-term pressure, as investors who placed their bets against Treasuries earlier in the year were forced to pull back when the market moved against them.
Despite the buying this week, many investors are still holding short positions, indicating that the pressure may continue and that returns could fall further, according to Ian Lingen, head of US price strategy at BMO Capital Markets.
A customer survey by BMO last week found that 71 percent of investors believe the next big step in Treasury yields will be bullish. “We sent a variety of inquiries along the lines of ‘How long will the current distortions last?'” Lingen said. “
Others expect that this week’s Treasury rally will prove temporary, and inflation will not.
In this environment, the Fed will soon have to begin the process of softening markets due to slowing bond purchases, perhaps as soon as it meets next week, according to Oliver Jones of Capital Economics.
He said the recent rally “may just be a pause after historically rapid sell-offs” in the first quarter of the year. “We doubt it will last.”
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