U.S. 10-Year Note Yield Falls to Fresh 2017 Low

U.S. government bond prices rallied broadly Wednesday, sending the yield on the benchmark 10-year Treasury note to a fresh 2017 low, as the latest signs of slowing inflation raise doubt over the Federal Reserve's plans for raising interest rates later this year.

The buying sent the yield on the benchmark 10-year Treasury note to 2.105% in recent trading, below the 2.147% ending level on June 6, which was the lowest close since Nov. 10. The yield dropped sharply from 2.206% Tuesday. Yields fall as bond prices rise.

The key boost for the bond market was a report showing the consumer-price index last month was up 1.9% on an annualized base, dipping below the Fed's 2% target again. Excluding food and energy, CPI rose 1.7% over the past 12 months through May, the smallest gain since May 2015.

Analysts say the data, along with a weak retail sales report, may not stop the Fed from raising short-term interest rates Wednesday afternoon, when the central bank concludes its two-day meeting. But they bolster some investors' belief that the Fed may be forced to stand pat during the second half of the year unless the deceleration in inflation proves to be transitory.

This view has played a big part in driving down long-term Treasury bond yields over the past few weeks and boosting demand for the Treasury's bond auctions earlier this week.

"The weak data certainly adds to the drumbeat of one hike and done for the year," said Larry Milstein, head of government and agency trading at R.W. Pressprich & Co.

Inflation chips away investors' purchasing power from their government bond investments over time and is a big threat to long-term Treasurys. Demand for long-term bonds rises when investors expect inflation to ease.

Demand for long-term bonds was so strong that on Wednesday the yield premium on the 10-year note relative to the two-year note fell to 0.815 percentage point. This would be the lowest level since September on a close basis, according to Tradeweb. The premium was 0.75 percentage point on July 8, 2016, the smallest since Nov 2007.

A shrinking premium is known as a flattening yield curve in the bond market. It is usually interpreted by investors as a warning sign that the growth momentum may be slowing down, leading to diminished inflation pressure.

The development in the bond market came as the Fed is scheduled to release its interest-rate statement Wednesday afternoon, followed by a press conference from Fed Chairwoman Janet Yellen.

The low unemployment rate suggests the labor market is approaching full employment, supporting tightening monetary policy. Lower Treasury bond yields, a weaker dollar and U.S. stocks -- which closed at record high Tuesday -- point to loosening financial conditions, allowing the Fed to raise interest rates.

Some traders warn that bond buyers may underestimate the Fed's desire to raise rates. One reason is that higher rates give the Fed some room to cut rates in response to the next economic downturn.

This buying in Treasurys "is irrational," said Charles Comiskey, head of Treasury trading at Bank of Nova Scotia. "The bond market may be mispricing the Fed," which could leave bond investors vulnerable to a potential reversal to higher yields.

Still, the bond market has caught those betting on higher yields wrong-footed this year. The 10-year Treasury yield has fallen from 2.446% at the end of 2016, even as the Fed raised rates in December and again in March. The bond market is countering against the consensus trade leading into 2017 that yields would extend their climb in late 2016.

A number of factors have sent yields lower instead: growing skepticism toward President Donald Trump's fiscal agenda; disappointing economic releases that raised some question toward the growth momentum; and U.S. Treasurys remain a bargain with their yields remaining higher compared with their peers in Germany, Japan and the U.K.

A massive pool of negative-yielding government bonds in Japan and Europe driven by those countries' unconventional bond-buying monetary stimulus highlights global investors' struggle to get income and drives money flowing into Treasurys. The amount of global negative-yielding sovereign debt outstanding rose to $9.5 trillion as of May 31, from $8.6 trillion on March 1, according to a report from Fitch Ratings Tuesday.

Some money managers and analysts say slowing inflation is complicating the Fed's strategy in normalizing its interest-rate policy. The risk for the Fed, say analysts, is that if inflation expectations become unanchored and fall further from here, it would make it harder for policy makers fulfill their inflation mandate. Therefore, the central bank may need to slow down the pace of tightening.

Inflation expectations tumbled, as indicated by the shrinkage of the 10-year break-even rate, or the yield premium investors demanded to hold the 10-year Treasury note relative to the 10-year Treasury inflation-protected security.

The 10-year break-even rate fell to 1.73 percentage points Wednesday, the lowest since early November. At this level, it suggests investors expect the U.S. inflation rate to run at an annualized 1.73% within the next 10 years, way below the Fed's 2% target.

A shrinking break-even rate also means some investors sold TIPS and migrated cash into Treasury debt, which contributed to the slides in Treasury yields.

"It makes tightening later this year much more difficult," said Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets. "We think this effectively takes September off the table."

Write to Min Zeng at min.zeng@wsj.com

(END) Dow Jones Newswires

June 14, 2017 11:30 ET (15:30 GMT)