U.S. Treasury bond yields spiked higher Monday, lifting yields on benchmark 2-year notes to the levels last seen prior to the global financial crisis, as investors re-set interest rate expectations in the wake of Fed Chair Jerome Powell's hawkish Jackson Hole address.
Powell's pledged to "forcefully" use the Fed's tools to bring down inflation, alongside a warning that doing so will bring "some pain to households and businesses" in the world's largest economy, caught many in the bond market by surprise Friday, given that the Fed's preferred measure of inflation continues to show consistent moves to the downside.
The core PCE Price Index recorded its first monthly decline in more than two years in July, according to data published Friday, suggesting consumer price pressures are beginning to ease amid tumbling gas prices and an improving labor market.
Ordinarily, that would be good news for bonds, which are penalized by high inflation rates that erode the present value of fixed income payments that are made in the future.
However, Powell's hawkish assessment of the current inflation environment, as well as the suggestion that the Fed won't be swayed from its rate-hike path by weaking growth prospects, has triggered a significant re-set for the bond market.
"The magnitude of the September rate hike still remains a coinflip, but the Fed members have refused to take comfort with the softer CPI print and continue to push for an aggressive fight against inflation," Saxo Bank strategists wrote Monday. "Inflation remains the overarching theme in all the Fed talk, and no comfort is being taken from the softening in July data."
"That puts a great deal of emphasis on the US jobs report due on September 2nd, and the US CPI report due September 13th," the bank added.
Benchmark 2-year note yields, which are highly-sensitive to changes in interest rate forecasts, were marked nearly 10 basis points higher from Friday's pre-Jackson Hole levels and trading at 3.48%, the highest since 2007.
At the same time, 10-year notes were marked 10 basis points higher at 3.13%, pegging the difference between the two benchmarks -- and the so-called inversion of the yield curve -- at 36 basis points.
According to a study from the San Francisco Federal Reserve, a sustained inverted yield curve has preceded all of the nine recessions the U.S. economy has suffered since 1955, making it an extremely accurate barometer of financial markets sentiment.
Adding further upward pressure to yields, which move in the opposite direction to prices, is the expected acceleration in sales from the Fed's $8.9 trillion balance sheet.
The Fed, which gathered around $4.5 trillion in Treasury, agency and mortgage bonds as part of its decade-long program of quantitative easing, unveiled plans last spring to begin allowing them to 'roll off' the balance sheet and not be reinvested.
The pace of that roll off will rise as of Thursday, however, from $47.5 billion a month to around $95 billion a month from September 1, keeping the Fed out of bond market purchases while pushing prices lower.
"The Fed is probably going to stop short of 4% in Fed Funds by year-end and wait to see what happens with that level in combination with the balance sheet reductions," said Louis Navellier of Navellier Calculated investing. "But that's a factor that the market can only guess at since it's happened only once before."
