Treasury Yields Extend Surge, 10-Years Top 1.5% On Reflation Bets

On Sep 27, 2021

U.S. Treasury bonds extended their recent slump Monday, lifting benchmark 10-year yields to the highest levels in three months, amid concerns over the debt ceiling and a resurgent ‘reflation trade’ linked to a hawkish Federal Reserve and surging energy prices.

So-called reflation trades have been pushing U.S. interest rate markets higher for much of the past week, sparked by the Federal Reserve’s suggestion that it could soon being trimming the pace of its $120 billion in monthly bond purchases, the first in a series of steps that could lead to an interest rate hike in the third quarter of 2022.

While some see the signal as a sign of confidence in the strength of the post pandemic recovery, others point to constraint-lead surges in oil and energy prices, the ongoing impact of supply chain disruptions, higher input prices and elevated shipping costs that could suggest inflationary pressures will embed themselves in the global economy for a longer period than many — including the Fed — have originally forecast.

Inflation is running at the hottest levels since 2008, although August CPI cooled somewhat, to 5.3% from last year, as used cars prices eased and travel costs abated amid a renewed wave in Delta variant infections.

Inflation is, in fact, the so-called “enemy of bonds” because it erodes the value of future payments.

Alongside that, bond investors are also grappling with the prospect of an expiration in the suspension of the $28.4 trillion U.S. debt ceiling, a move that could trigger both a government shutdown and the prospect of a technical default on some Treasury bills and Treasury notes as early as October.

“We understand completely the thought process that the most likely scenario is a flight-to-safety to Treasuries by way of protection,” said ING’s chief international economist James Knightley, referring to a possible rally in government bond prices that would result in lower Treasury yields. “But there’s also a reasonable probability that moments like these could be an opportunity to recalibrate US yields to more sensible valuations, and that means much higher.”

“It could in fact be a bit of both. First lower — think sub-1% for the 10-yaer n the flight to safety and Fed backstop narrative — but then higher, towards 2% on a combination of both credit and fundamental recalibration,” he added. “One thing is for sure though, potential extreme outcomes like these breed volatility. Brace for it if nothing has happened by the end of September.”