Bond Report: U.S. government bonds rise as Fed lifts key interest rates

Treasury yields rose Wednesday after the Federal Reserve raised its key interest rate and dropped language that rates would remain below its long-term rate in its June policy statement.

What are Treasurys doing?

The 10-year Treasury note yield TMUBMUSD10Y, +0.56% picked up 2.6 basis points to 2.983%. The 2-year note yield TMUBMUSD02Y, +1.61%  climbed 4.5 basis point to 2.586%, while the 30-year bond yield TMUBMUSD30Y, +0.27% was up by 0.9 basis point to 3.101%.

The rate hike decision had the effect of flattening one part of the yield curve. The yield gap between the 5-year note TMUBMUSD05Y, +0.97% and the 30-year bond, a popular gauge of the curve’s slope, narrowed to 25.5 basis points, or 0.255 percentage points, marking its narrowest level since 2007.

Bond prices move in the opposite direction of yields.

What’s driving markets?

As expected, the Fed raised the fed-funds rate by a quarter percentage point to a range of 1.75% to 2.00%, marking its second increase in 2018 and its seventh since the commencement of a path of normalization for the central bank since 2015.

The central bank took away longstanding language that rates would remain below its expected long-term rate in its policy statement, which investors construed as a potentially hawkish sign. The dot plot, a plot of projections for future interest rate increases by policy makers, now reflects two additional rate hikes this year. The median forecast for the fed-fund rates by the end of the year now stands at 2.4%, compared with the March forecast of 2.1%.

Investors also said the announcement to have a press conference after every Fed meeting represents a shift to winnow away forward guidance. With every meeting now potentially becoming a turning point for monetary policy, the move would give extra flexibility for the central bank to change course when it sees fit.

An increase in uncertainty about central bank policy could lift longer-dated yields higher as forward guidance has been blamed for making the central bank’s rate-hike path more predictable, depressing the term premium, the extra yield demanded for owning longer-dated bonds if interest rates don’t move as expected.

See: 5 challenging questions Fed chief Powell may encounter

Read: Here’s one rate the Fed won’t raise by a quarter-point

What did market participants say?

“They pulled forward the rate hikes, but not the total number of hikes. That’s probably a response to fiscal stimulus, pulling a lot more growth into the short-run. My interpretation is that they haven’t tweaked their estimates for the potential growth rate or for long-term inflation as their basic forecasts haven’t changed that much,” said Kathy Jones, chief fixed income economist for Schwab Center for Financial Research.

Of the decision to hold a news conference with every meeting:

“There is some truth the Fed wants to make forward guidance less prescriptive, and add a little more uncertainty. We’ve had very low volatility, and getting back to normal would change that,” said Jones.

“The hike will surprise no one, but tweaks to the Fed’s forward guidance have provoked more of a stir in markets. The FOMC is now signalling two more hikes this year and has dropped its increasingly stale signal to markets that rates will remain for some time below those levels expected in the long term. This shift reflects the robust domestic growth backdrop, which is being fermented by a late cycle fiscal stimulus,” said James McCann, global economist for Aberdeen Standard Investments.

What else was on investors’ radar?

Producer prices for May jumped 0.5%, leaving the year-over-year rate at 3.1%, a six-year high. The buildup of pipeline inflation pressures could add impetus to rate hikes.

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