Long-dated U.S. Treasury yields are likely to surge further until investors receive a convincing indication from a Kevin Warsh-led US Federal Reserve that it remains committed to fighting inflation, according to T. Rowe Price.
Arif Husain, head of global fixed income and chief investment officer at the $1.89 trillion asset manager, said the last week’s sell-off in long-term government bonds, despite the US Fed’s widely expected decision to leave interest rates unchanged, showed market’s doubt about the central bank’s resolve on containing price pressures.
“Although a hold was the consensus, the reaction suggested to me that the bond market was demanding a more forceful demonstration of the Fed’s inflation-fighting credibility, with an immediate hike viewed as the clearest proof,” Husain said.
“Until the market receives the proof of Fed credibility it is seeking, I can see long-end yields rising in the short term. The move could be larger if the data come in hot or oil makes another run toward USD$100 per barrel.”
He said financial markets may eventually force a policy response but noted that a US Fed led by Warsh could be less inclined to provide advance guidance on future interest-rate decisions.
“Without clear forward guidance, it is difficult to identify what could act as a circuit breaker if the market continues to test the Fed’s resolve,” Husain said.
The impact could extend well beyond government bond markets as Warsh’s stated preference for a smaller US Fed balance sheet, combined with reduced reliance on forward guidance, could increase both implied and realised market volatility over the medium to long term.
“That volatility may initially emerge in rates markets before spreading into credit and potentially equity markets,” Husain said.
Beyond monetary policy, Husain argued that Treasury yields face longer-term structural pressures stemming from the US government’s growing financing needs.
“In my view, the U.S. yield curve ultimately needs to move materially higher and become steeper to attract sufficient capital to fund the fiscal deficit, amid competition from other sovereign issuers and the substantial financing needs associated with data centre investment,” he said.