Treasury Bonds Post Biggest Monthly Rally Since January

U.S. Treasury bonds rallied broadly Friday as a lackluster wage inflation gauge clouded investors' perception of the likeliness of an interest-rate increase by the Federal Reserve in September.

Friday's price gain capped the biggest monthly rally for the benchmark 10-year note since January. July was the first month the note strengthened since March.

The yield on the benchmark 10-year Treasury note fell to 2.207% on Friday from 2.268% on Thursday and 2.335% at the end of June. It marks the yield's lowest closing level since July 8. Yields fall as prices rise.

The 0.2% rise in the employment-cost index Friday was the smallest in three decades, pointing to sluggish wage inflation. The report underscores the challenges for the Fed to dial back crisis-era monetary policy amid sluggish global economic growth, subdued inflation and highly accommodative monetary policy around the globe.

Weaker commodities this month have pushed down inflation expectations. A gauge of long-term U.S. inflation expectation has fallen this week to the lowest level since March. A stronger dollar is hurting U.S. exports while lowering prices of imported goods, making it difficult for the Fed to push inflation to its 2% target in the medium term.

The report "is a red light for the Fed," said Jonathan Lewis, chief investment officer at Samson Capital Advisors LLC, which has $7.4 billion in assets under management. "This economic recovery is not strong enough to generate consistently positive economic data, let alone consistent upward pressure on wages."

Mr. Lewis said he is skeptical the Fed can raise rates in September and added that Friday's report is "a green light for investors to move out of cash and into bonds."

The odds of a rate increase by the Fed at the September policy meeting were 38% on Friday, compared with 48% on Thursday and 40.5% a week ago, according to traders. The calculations are based on implied yields from Fed-funds futures which are used by investors and traders to place bets on central-bank policy.

The yield on the two-year note, among the most sensitive to changes in the Fed's interest-rate outlook, pulled back Friday from near the highest level of the year. The yield fell to 0.676% from 0.731% on Thursday.

Daniel Mulholland, senior U.S. Treasury trader at Credit Agricole in New York, said the door remains open for the Fed to raise rates in September amid solid jobs growth. Fed Chairwoman Janet Yellen "has previously told us that wage growth is not a pre-condition for rate hikes," said Mr. Mulholland. "The Fed has told us they will be data dependent and there are two more payroll reports prior to" the Fed's next policy meeting in September, he said.

Money managers say financial-market volatility would rise leading into the September policy meeting.

"Data dependency is a nice option for the Fed, but it makes market more prone to overshooting in either direction after each major data release," said Zhiwei Ren, managing director and portfolio manager at Penn Mutual Asset Management Inc., which has $20 billion in assets under management.

The Fed's ultraloose monetary policy following the 2008 financial crisis has sent prices of many stocks and bonds to elevated levels, raising concerns about whether financial assets could hold up once the Fed starts a tightening campaign for the first time in nearly a decade.

The $12.7 trillion U.S. government debt market is crucial to not only the U.S. economic outlook but also to the health of global financial markets. The yield on the benchmark 10-year Treasury note is used to price a range of financing activities including mortgages, corporate bond supply and business loans.

The 10-year yield fell this month for the first time since March after posing the biggest three-month rise in two years during the second quarter. The swings put the yield modestly higher than 2.173% at the end of last year.

Many money managers expect the yield to rise modestly during the balance of this year, seeing it as a normalization of the bond market in response to the Fed's shift away from ultraloose monetary policy. But they expect the Fed's gradual approach in tightening and contained inflation to keep a lid on a rise in the 10-year yield.

U.S. bond yields are higher compared with their counterparts in many other developed countries, including Germany, Japan, the U.K. and France. A stronger dollar boosts foreign investors' investments in U.S. financial assets.

"We might see a knee-jerk reaction to higher yields once the Fed starts raising rates, but without inflationary pressures the move is likely to be short lived," said Sean Simko, head of fixed-income management at SEI Investments, which has $258 billion in assets under management.

Shorter-dated Treasury yields rose in July as investors migrated money into longer-dated bonds to prepare for a potential rate increase in September.

In the past three tightening cycles, the yield on the two-year Treasury note rose at a faster pace than the yield on the 10-year Treasury note. That is because shorter-dated bond yields are pinned by the Fed's short-term policy rate so they are more vulnerable to a shift in the Fed's policy.


 5/8%   2-year   99 29/32    up 3/32   0.676%     -5.5BP

 7/8%   3-year   99 21/32    up 6/32   0.988%     -6.5BP

1 5/8%   5-year  100 11/32    up 11/32  1.550%     -7.3BP

   2%   7-year  100 12/32    up 14/32  1.942%     -7.1BP

2 1/8%  10-year    99 8/32    up 17/32  2.207%     -6.1BP

2 1/2%  30-year  101 10/32    up 12/32  2.933%     -2.0BP

2-10-Yr Yield Spread: +153.1BPS +153.7BPS

Source: Tradeweb/WSJ Market Data Group

(By Min Zeng)