U-Turn in Bonds Has Bulls Envisioning Sub-4% US Two-Year Yield

(Bloomberg) — A week after the US two-year yield topped 5% en route to its highest levels since 2007, the mood has changed completely and bond bulls are mapping out a course for 4%, if not lower.

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The prospect that a slowdown in inflation will allow the Federal Reserve to cut interest rates sooner and more deeply than markets are currently pricing in should allow the two-year rate to reach that level this year, according to Pendal Group Ltd and TD Securities.

The shortest-maturity Treasury note’s yield dipped below 4.62% to the lowest level in nearly a month Thursday after a gauge of wholesale prices was softer than expected. On Wednesday, data showed US consumer price inflation eased at a faster-than-expected pace in June, sparking a 13-basis-point drop in two-year yields, the biggest since May.

“Inflation has been such a big problem for the past year, and we’ve stepped down into a new zip code,” said Amy Xie Patrick, head of income strategies at Pendal in Sydney. She’s been favoring two-year Treasuries “on the likelihood that the Fed will cut sooner and more aggressively than definitely what they say, but also than what the market currently prices.”

Gennadiy Goldberg, head of US interest-rate strategy at TD, forecasts a 3.95% two-year yield at year-end.

US core CPI inflation slowed to 4.8% last month, the lowest since 2021. That ignited rallies in bonds and stocks and a slide in the dollar as investors unwound bets that the Fed would raise rates again following an expected hike this month. Those moves continued into Thursday.

Fed Chair Jerome Powell’s favored gauge of inflation — which measures core services excluding rents — slowed to a 1.4% annual pace based on its three-month annualized trend. That underscores the likelihood that this slowdown in price pressures is sustainable, Xie Patrick said.

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TD predicts a US recession in the first quarter and declining inflation leading the Fed to slash rates by 300 basis points next year.

“We are looking for lower yields than most as we have a lot of Fed rate cuts penciled in for 2024,” Goldberg said in a telephone interview Thursday. Assuming a quarter-point hike in July that brings the range for the policy rate to 5.25%-5.5%, the cuts TD expects would bring it back to 2.25%-2.5%. A 300-basis-point drop “may seem like a very large number, but in a historical context that’s a very small cutting cycle,” he said.

Swaps contracts that attempt to predict Fed moves see a July hike as a near-certainty, and roughly one-in-four odds of an additional one. They price in a quarter-point cut no sooner than March and around 160 basis points of easing in 2024.

–With assistance from Nicholas Reynolds.

(Updates rates throughout, adds comments from TD Securities strategist.)