Long-dated yields tumble, curve flattens after Fed

NEW YORK: Long-dated yields tumbled on Thursday and the yield curve flattened as some investors appeared to have been caught flat-footed by the U.S. Federal Reserve's comments that it is in no hurry to pare bond purchases and expects to raise rates in 2023.

Yields initially spiked after the Fed said on Wednesday that policymakers expect to increase rates two times in 2023.

Two-year and five-year notes, which are the most sensitive to interest changes, saw the largest yield increases.

But long-dated yields dropped on Thursday and the yield curve flattened sharply in what appeared to be repositioning from the Fed statement, with people that had been betting on yield curve steepening scrambling to cover those trades.

"There were probably several bets that the Fed was going to taper, or at least talk about tapering, and they really didn't mention it at all, and so I think whoever decided to put a big steepening exposure on is getting stopped out," said Tom di Galoma, a managing director at Seaport Global Holdings in New York.

The biggest move was in the yield curve between five-year notes and 30-year bonds, which flattened as much as 117 basis points, the smallest yield gap since November. The curve has flattened from 140 basis points before the Fed statement.

Fed Chair Jerome Powell said there had been initial discussions about when to pull back, a conversation that would be completed in coming months as the economy continues to heal.

Many analysts think the Fed will announce plans to taper at its Jackson Hole, Wyoming, economic symposium in August, with bond reductions unlikely to occur until late this year or early next year.

Fed funds futures traders are pricing in a hike in January 2023.

Some analysts said expectations of hikes sooner could also be denting the inflation outlook.

"The market was definitely caught a little bit surprised by two hikes in 2023 ... that takes away from inflation pressures," said Justin Lederer, an interest rate strategist at Cantor Fitzgerald in New York.

Benchmark 10-year yields were last 1.511pc, after reaching 1.594pc on Wednesday.

Five-year yields were 0.881pc, after rising to a two-month high of 0.913pc on Wednesday.

Two-year yields reached a one-year high of 0.217pc on Thursday, and were last 0.215pc.

The Treasury saw strong demand for a $16 billion sale of five-year Treasury Inflation-Protected Securities (TIPS), which was likely helped by a sharp sell-off going into the auction.

Breakeven rates on the debt, which measure expected annual inflation for the next five years, dropped to 2.30pc before the auction, from 2.40pc earlier, and rose back to 2.39pc in afternoon trading.

The cost of borrowing Treasuries in the overnight repurchase agreement market (repo) rose after the Fed on Wednesday raised the interest rate it pays banks on reserves by five basis points to 0.15pc, and the rate it pays on overnight reverse repurchase agreements to 0.05pc from zero.

The move will give some relief to money fund investors who are struggling to find high quality, short-term assets and have faced paltry returns with yields nearing zero. The Fed's reverse repo operation saw a record $756 billion in demand on Thursday.

Overnight repo rates increased to six basis points, from one basis point before the Fed move.

Yields on one-month Treasury bills increased to four basis points, from one basis point.

Market gauges for liquidity such as the U.S. swap and cash market spreads remained quiet on Thursday.