The bond market’s worst-case scenario isn’t a Fed rate of 6%. It’s this.

“The worst-case scenario would be if inflation trends the other way,” England said, adding that isn’t his base-case scenario, but could risk triggering the Federal Reserve to resume jumbo rate increases.

Minutes of the Fed’s February policy meeting released on Wednesday showed unanimous support for further rate hikes, after raising its benchmark rate earlier in the month by 25 basis points to a range of 4.5%-4.75%.

Bonds, along with many other asset classes, suffered last year when the Fed used a string of jumbo rate hikes of 75 basis points to quickly increase borrowing costs with the goal of taming inflation that hit a 9.1% summer peak.

Rates jitters have resumed recently, including after last week’s blowout jobs report and still high inflation reading helped push the yield on the 2-year Treasury
TMUBMUSD02Y,
4.695%,
which is sensitive to the Fed’s policy rate, above 2.7% on Tuesday, the highest since 2007.

While today’s higher “risk-free” Treasury yields have been a positive for investors buying short-term debt, the hope has been that slightly higher peak rates won’t risk triggering a deep U.S. economic recession.

“The beauty of having this yield is that you have a lot more cushion,” England said, of the potential for yields to climb a bit more this year. “You won’t have as much pain if rates went to 6%.”

Markets realign with Fed

Stocks on Tuesday booked their worst daily drop in more than two months, while continued pressure on Wednesday left the Dow Jones Industrial Average
DJIA,
-0.27%
in the red for the year.

Since last week, more investors have embraced a scenario where the Fed raises rates modestly in the next few months, but then keeps rates in restrictive territory for a while.

“In the past few trading sessions, traders have capitulated to what the Fed has been saying for quite some time,” said Chip Hughey, managing director of fixed-income at Truist Advisory Services.

“Not only does the fed-funds rate need to continue to rise, but once it’s reached the endgame, the plan is to stay at those restrictive levels for some time,” Hughey said.

The Fed in December projected its benchmark rate to peak at a range of 5% to 5.25%.

One risk is that today’s meatier bond yields would become less attractive if the central bank still can’t make substantial headway in getting inflation, pegged at 6.4% in January, down toward its 2% annual target.

“The simple fact is that the Fed is going up on interest rates,” said Kent Engelke, chief economic strategist at Capitol Securities Management. “The market is just now getting around to accepting the Fed’s version of reality.”

But as Hughey at Truist also pointed out, the jury is out on if a slowing U.S. economy ends up in a mild recession or something worse, particularly since tighter monetary policy tends to work with a substantial lag before making impact.

“The reality is the longer that Fed policy is set to restrictive levels, that does increase the chances of a harder landing,” he said.

Despite the recent selloff, the S&P 500 index
SPX,
-0.11%
w as still up 3.9% on the year through Wednesday, while the Nasdaq Composite Index
COMP,
-0.20%
was 10% higher, according to FactSet.