The U.S. bond market is sending a note of caution to the Federal Reserve, which is on track to raise interest rates in June.
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Hedge funds and money managers have built up the biggest net wagers since 2008 betting long-term Treasury yields will fall. At the same time, wagers betting on an increase in short-term interest rates are near the highest level since 1993.
This divergence is happening at a time when the yield premium on the 10-year note relative to the two year has been shrinking. In the bond world, this is known as a flattening yield curve and is a development that traders see as a sign of waning confidence in the growth outlook. A widening premium, or a steepening yield curve, is taken to indicate momentum in the economy.
Both the wagers and flattening yield curve suggest investors are bearish on short-term debt and migrating cash into long-term government bonds. This type of allocation is typical when investors anticipate tightening monetary policy may slow down the economy. The Fed could err by increasing rates when signs have emerged that inflation pressure is decelerating, some analysts and investors say.
"The Fed has cited growing inflation as one of the remaining catalysts to continue its rate normalization," said Kevin Giddis, head of fixed-income capital markets at Raymond James. "In absence of that data being confirmed, I believe that they run the risk of tightening too much. In essence, choking off the recovery in the process."
A report Friday showed the U.S. consumer-price index excluding food and energy last month fell below the Fed's 2% target for the first time since October 2015. A closely watched survey from University of Michigan this month showed consumers expected an inflation rate of 2.3% during the next five to 10 years, the lowest level since the survey started in 1979.
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Meanwhile, the U.S. dollar has failed to gain traction this year. The ICE dollar index, which measures the dollar against major counterparts, fell on Tuesday to the lowest since November. This gives the Fed some breathing room when it comes to tightening policy, said Ken Taubes, U.S. chief investment officer at Pioneer Investments.
Even so, Krishna Memani, chief investment officer at OppenheimerFunds, said there is "no reason for the Fed to tighten" given the level of uncertainty in the economy. "While June sounds like a done deal, further signs of a slowdown in inflation or growth are likely to push the Fed to delay its tightening plan," he said.
Some analysts also say investors shouldn't overplay signals from the bond market, which may be distorted due to significant bond buying by central banks in Europe and Japan. The bond-buying programs have helped drive down global yields to historic lows.
But net bets wagering on higher prices, or lower yields, via 10-year Treasury futures hit $22.9 billion in the week ended May 9 -- the highest since January 2008, according to TD Securities.
That is a reversal from February, when net bets wagering on the opposite -- higher yields -- soared above $40 billion. The shift marks a sharp departure from the consensus trade earlier this year that yields would extend their post-election climb and reflect stronger growth and higher inflation.
Fed officials signaled in their interest rate statement earlier this month that they expect the economy to rebound after a soft patch in the first quarter. But some investors are skeptical that growth will accelerate and President Donald Trump will be able to push through fiscal stimulus. Mr. Trump's decision this month to fire FBI Director James Comey also injected a fresh layer of uncertainty.
Net bets wagering on a rise in U.S. short-term rates via eurodollar futures climbed to $3.16 trillion in the week that ended May 9, according to TD Securities. That is close to the level reached in early April, when the wagers were the highest since data started in 1993, according to Cheng Chen, U.S. strategist at TD Securities.
The 10-year yield was 2.329% Tuesday, down from 2.446% at the end of 2016. Yields fall as bond prices rise. The yield on the two-year note, highly sensitive to the Fed's policy outlook, was 1.299%, near the highest since 2009, and up from 1.159% at the end of last year.
Few investors expect the yield curve to invert -- when the two-year note's yield rises above that on the 10-year note. An inverted yield curve has predicted recessions in the past, including that one that followed the 2008 financial crisis.
Colin Robertson, managing director of fixed income for Northern Trust Asset Management, said he sees only a 10% probability that the U.S. economy would slip into a recession in the next two years.
But if the yield curve continues to flatten, that would cause him to doubt that the Fed will continue to raise rates in September, following one increase in June, he said.
The cautious tone in the haven debt market comes as U.S. stock markets are soaring. This suggests the Fed is moving at a predictable and measured pace, making the probability of a market shock like the one in 1994 less likely, according to Russ Certo, managing director of rates trading at Brean Capital LLC.
"The Fed has been doing a pretty good job communicating its plan to investors lately," he said. "The Fed is in the right place right now."
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(END) Dow Jones Newswires
May 16, 2017 18:17 ET (22:17 GMT)