There is no escaping the biggest bond loss in decades as the Fed continues to hike

(Bloomberg) — Investors who may be looking to the world’s largest bond market to bounce back soon from their worst losses in decades seem doomed for disappointment.

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The U.S. jobs report on Friday showed the economy’s momentum ahead of the Federal Reserve’s escalating easing effort, with businesses adding jobs quickly, wages rising and more Americans entering the workforce. While bond yields fell as data showed a slight easing of wage pressures and a rise in the unemployment rate, the overall picture fueled speculation that the Fed is poised to keep raising rates — and keep them there — until until the burst of inflation recedes.

Swaps dealers are pricing in a slightly better-than-equal chance that the central bank will continue to raise the benchmark rate by three-quarters of a percentage point on September 21 and tighten policy until it reaches around 3.8%. This suggests more downside potential for bond prices because the 10-year yield has been at or above the Fed’s peak rate during previous cycles of monetary policy tightening. That yield is around 3.19% now.

Inflation and the Fed’s aggressiveness have “bitten the markets,” said Kerrie Debbs, a certified financial advisor at Main Street Financial Solutions. “And inflation won’t go down in a few months. This reality bites.”

The Treasury market has lost more than 10% in 2022, putting it on pace for its biggest annual loss and the first consecutive annual decline since at least the early 1970s, according to a Bloomberg index. A rally that began in mid-June, fueled by speculation that the recession would result in interest rate cuts next year, was largely erased as Fed Chairman Jerome Powell emphasized that he was focused squarely on reducing inflation. Yields on the two-year bond hit 3.55% on Thursday, the highest since 2007.

At the same time, short-term real yields — or those adjusted for expected inflation — have risen, signaling significant tightening of financial conditions.

Rick Rieder, the global chief investment officer of fixed income at BlackRock Inc., the world’s largest asset manager, is among those who believe long-term yields may rise further. He said in an interview on Bloomberg TV on Friday that he expects the Fed to raise its policy rate by 75 basis points this month, which would be the third consecutive move of that size.

Friday’s jobs report showing a slowdown in payroll growth allowed markets to breathe a “sigh of relief,” according to Rieder. He said his firm is buying some short-term fixed-income securities to take advantage of the big rise in yields, but he believes those with longer maturities have further upside.

“I can see interest rates going up over the long term,” he said. “I think we’re in a range. I think we are at the upper end of the range. But I think it’s very hard to say we’ve seen the highs right now.”

The employment report was the last major look at the labor market before the Federal Open Market Committee meets this month.

A number of economic reports are scheduled to be released in the coming holiday-shortening week, including surveys of purchasing managers, the Fed’s Beige Book on regional conditions and weekly jobless claims. US markets will be closed on Monday for the Labor Day holiday and the most important indicator ahead of the Fed meeting will be the September 13 consumer price index release.

But the market will closely scrutinize comments from a number of Fed officials scheduled to speak publicly next week, including Cleveland Fed President Loretta Mester. He said on Wednesday that policymakers should push the fed funds rate above 4% by early next year and said he did not expect any rate cuts in 2023.

Greg Wilensky, head of U.S. fixed income at Janus Henderson, said he’s also focused on the upcoming release of wages data from the Atlanta Fed ahead of its next policy meeting. On Friday, the Labor Department reported that average hourly earnings rose 5.2 percent in August from a year earlier. That was slightly less than the 5.3% economists had expected, but still showed upward pressure on wages from the tight labor market.

“I’m in the 4% to 4.25% camp for the terminal price,” Wilensky said. “People are realizing that the Fed is not going to stop on softer economic data unless inflation weakens dramatically.”

The specter of aggressive Fed tightening has also hammered stocks, leaving the S&P 500 Index down more than 17% this year. While U.S. stocks rallied from June lows through mid-August, they have since given back many of those gains as bets on an impending recession and rate cuts in 2023 have failed.

“You have to stay humble about your ability to predict data and how interest rates will react,” said Wilensky, whose core bond holdings remain underweight bonds. “The worst is over as the market does a more reasonable job of pricing where prices should be. But the big question is what happens to inflation?’

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