‘No-landing’ scenario and strong stock market raises the risk of a bonds selloff

Feb 23, 2024

U.S. stocks soared to new heights on Friday amid growing investor optimism, which gave way to a new risk in financial markets: The possibility of a strong selloff in long-term U.S. government debt.

Yields on long-term Treasurys — which were lower on the day, but not far from some of their highest levels of the year — may be due for an adjustment that takes into account January’s strong economic data, easy financial conditions, and the risk of more comments by Federal Reserve officials on the need to keep fighting inflation, strategists said.

As recently as late October, the benchmark 10-year yield briefly broke above 5%, before investors and traders ended up settling on a narrative that inflation would likely keep falling in 2024 by enough to necessitate multiple interest-rate cuts by the Federal Reserve. Now, a stream of hotter-than-expected reports for January may begin to upend that thinking and risks burning anyone who had been counting on Treasury yields to fall sustainably from last year’s peak.

Economists have scaled back on the odds of a U.S. recession, while the Dow Jones Industrial Average DJIA and S&P 500 SPX were marching toward more records even though some of Friday’s earlier momentum fizzled. Meanwhile, strategists at BofA Securities flicked at the possibility that the 10-year Treasury yield BX:TMUBMUSD10Y may need to rise closer to 4.5% versus Friday’s level of around 4.25%.

The stock market has more room to rally, said Nancy Tengler, chief executive and chief investment officer of Laffer Tengler Investments in Scottsdale, Ariz., which managed $1.2 billion as of December. She compared the current environment to the 1990s, when inflation averaged above 3%, the 10-year yield hovered between 5%-7% and stock prices soared.

Read more: Wall Street is bracing for more strong U.S. economic and inflation data next week

January’s nonfarm-payrolls gain came in at a surprisingly strong 353,000, while the consumer-price index for that month showed inflation continued to be a challenge. The data created “all these fears of overheating and yet the stock market has been going up over time, so the sentiment is more of a no landing than a soft landing, or a ‘boom-flation’ in which growth stays high but inflation remains above the Fed’s 2% target,” said Will Compernolle, a macro strategist at FHN Financial in New York.

“Yields have to go up to compete with the valuations on equity, but I don’t think a 5% 10-year yield will come to fruition,” he said via phone on Friday. “I’m a proponent of the idea that the January data was a fluke and that subsequent inflation and labor data will show that an overheating U.S. economy is not a new trend.”

Nonetheless — between now and June, when many expect the Fed to deliver its first rate cut — confidence in U.S. growth prospects could drive up long-term Treasury rates, which would hurt banks that got back into the U.S. government-debt market between October and January on the view that yields had reached their peak, according to Compernolle.

The likelihood of a no-landing scenario is small, but growing. On Tuesday, a team at Deutsche Bank DB, +1.20% wrote that the rates market was pricing in a 10%-25% probability of such a scenario this year, based on December overnight index swaps. George Efstathopoulos, an Asia-based Fidelity International money manager who sold most of his 10- and 30-year Treasury holdings in December, told Bloomberg that a no-landing scenario has been growing.

While fed-funds futures traders have pulled back on expectations for as many as six or seven quarter-point rate cuts by December, they’re clinging to a likelihood of at least three such moves. By contrast, traders of options tied to the Secured Overnight Financing Rate have been flirting with the idea of another Fed rate hike.

From now through June, “the focus is going to be on inflation,” said Eric Sterner, chief investment officer at Apollon Wealth in Mount Pleasant, S.C., which manages around $7 billion. “We know the last mile is going to be difficult and bumpy. The big question is, `will the consumer and labor market remain resilient?’”

Sterner told MarketWatch that he stands by his base-case view of three quarter-point Fed rate cuts this year and argued against the notion of an impending bond-market selloff on a “no-landing” scenario. In his view, “yields will drop eventually partly because the Fed will be cutting rates at some point this year. We think the economy is slowing down, even though it’s been more resilient than many expected.’’

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