Treasuries Rally with Yields Dropping, Fed Cuts Eyed

Key Takeaway

• Treasuries build on last week's gains, with two-year yields down nearly 20 basis points to 4.8%, and 10-year yields near 4.5%.
• Morgan Stanley advises buying bonds, predicting rapid inflation slowdown; Charles Schwab sees potential for two Fed rate cuts this year.
• Despite optimism, Barclays warns against overestimating the likelihood of a July Fed rate cut; $125 billion in Treasury auctions could pressure yields.

Treasury Rally Gains Momentum

The Treasury market has seen its most significant weekly advance this year, with strategists from Morgan Stanley predicting further gains. Despite a slight change in yields, most have dropped by 10 to 20 basis points over the past week, influenced by a Federal Reserve meeting and US economic data that revived expectations for at least two interest-rate cuts within the year. This shift comes after a challenging month in April, where such expectations had diminished, marking it as the worst month of the year for the market.

The two-year Treasuries have seen a notable decrease of almost 20 basis points over the past week, stabilizing around 4.8%, while the 10-year note's yield has dropped about 15 basis points to approximately 4.5%. Morgan Stanley's strategists have encouraged investors to "buy bonds," anticipating a rapid slowdown in inflation after a stagnant first quarter. Kathy Jones from Charles Schwab echoed this sentiment, expressing a positive outlook on Treasuries and predicting two rate cuts by the Fed this year.

Divided Wall Street and Auction Pressures

Despite the optimistic forecasts, Wall Street remains divided on the feasibility of Fed rate cuts. Barclays Plc strategists have advised against the prevailing market sentiment, suggesting that the pricing for a Fed rate cut by July is overly optimistic. This skepticism is partly due to interpretations of the recent weaker-than-expected April employment data.

Moreover, the Treasury market is bracing for a series of auctions that could potentially increase yield pressures. The upcoming sales, totaling $125 billion in three- and 10-year notes and 30-year bonds, are expected to test the market's appetite for US debt. This comes after the Treasury market experienced a 2.3% loss in April, followed by a 1% gain last week, highlighting the volatile nature of the market.

Market Dynamics and Inflation Concerns

The recent cooling in the US labor market has provided a glimmer of hope for a more substantial rally in US Treasuries. Federal Reserve Chair Jerome Powell's dovish comments, suggesting potential rate cuts, have further fueled this optimism. However, the persistent issue of sticky inflation remains a significant barrier to drastic central bank actions, likely keeping bond yields within their recent ranges.

The upcoming auctions of $125 billion in Treasury securities will critically test the market's demand, especially for longer-dated debt, which has seen waning interest among investors due to inflation uncertainties and fiscal policies. The preference for shorter-term US securities reflects a cautious approach towards the long end of the curve, with market participants adjusting their expectations to nearly two full rate cuts this year.

Street Views

• Morgan Stanley Strategists (Bullish on Treasuries):

  "Buy bonds based on their view that inflation will slow rapidly after stalling during the first three months of the year."

• Kathy Jones, Charles Schwab (Bullish on Treasuries):

  "The Treasury market had swung too far toward bearishness and is now correcting. We are positive on Treasuries and continue to see two rate cuts by the Fed this year."

• Barclays Plc Strategists (Bearish on expectations for Fed rate cuts):

  "Recommended selling August futures on the federal funds rate, saying it prices in too high a chance of a Fed rate cut by July. Investors are extrapolating too much from last week’s weaker-than-anticipated April employment data."

• Earl Davis, BMO Global Asset Management (Neutral to Cautiously Optimistic on Treasuries):

  "The market was extremely oversold... But the underlying reason that drove yields higher is still there," and likely to reassert itself.