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Bond Report: Two-year Treasury yield drops as traders reconsider rate-hike expectations

U.S. Treasury yields fell Thursday, with the 2-year rate posting its biggest one-day drop since March, as the Bank of England held off on a widely anticipated interest rate increase and traders reassessed their expectations for global central bank policy.

The BoE’s decision took some of the focus off the Federal Reserve’s announcement on Wednesday that it will begin tapering monthly bond purchases and remain patient about raising interest rates.

What are yields doing?

The 2-year Treasury note yield

fell 6.1 basis points to 0.415% from 0.476% Wednesday afternoon. That’s the biggest one-day decline since March 23.

The yield on the 10-year Treasury note BX:TMUBMUSD10Y dropped 5.3 basis points to 1.524%, compared with 1.577% at 3 p.m. Eastern on Wednesday. That’s the lowest level since Oct. 14.

The 30-year Treasury bond yield

declined 2.1 basis points to 1.963%, versus 1.984% since late Wednesday.

It was the biggest daily declines for the 10- and 30-year rates in roughly a week, based on 3 p.m. levels, according to Dow Jones Market Data.

What’s driving the market?

Overseas, the Bank of England opted to hold off on a widely expected interest-rate hike on Thursday that futures markets had fully priced in. Norway’s central bank also left its key interest rate unchanged, at zero, during Thursday’s monetary policy meeting, as expected, but said rate increases could begin much sooner than it previously projected.

The BoE’s decision forced traders to reconsider their expectations for how much central banks are willing to raise rates in the face of elevated inflation pressures around the world and a global economic growth slowdown. Yields on U.K. government bonds fell, along with U.K. swap rates, as traders priced in less monetary policy tightening following the BoE’s decision, according to Tradeweb data.

Thursday’s decline in Treasury yields was seen by some traders as an indication that  investors remain confident the Fed will ultimately keep inflation under control, and as a sign the growth outlook may have diminished. Even so, the differentials between yields on various Treasurys widened on Thursday, according to Tradeweb data, suggesting that worrisome signs of an economic slowdown seen over recent weeks have eased up a bit.

At the conclusion of its Wednesday policy meeting, the Fed delivered what many analysts regard as a “dovish” taper. Policy makers said they would begin scaling back on monthly asset purchases later in November at a pace that would wind down the bond-buying program by the middle of next year. However, Fed Chairman Jerome Powell said policy makers would be patient about raising rates, although they would stand ready to act as needed in the face of higher inflation.

See: Fed still thinks surging U.S. inflation won’t last, but it’s now hedging its bets

The Fed statement and Powell’s remarks at his press conference underscored the expectation that inflation pressures are expected to prove “transitory,” fading as supply-side bottlenecks resolve themselves, though Powell did say risks to the inflation outlook were skewed to the upside.

Friday brings the U.S. October nonfarm payrolls report, with economists looking for payrolls to rise by 450,000 and the unemployment rate to tick down to 4.7% from 4.8%. Of particular interest to traders, however, will be the labor-force participation rate, which remains below pre-pandemic levels. A failure to bust out of the tight range that has prevailed for the rate would likely mean that even higher wages are needed to entice workers back, leading to further inflation.

Read: Traders are questioning if Federal Reserve has missed the boat on inflation ahead of Friday’s U.S. jobs report

Data released Thursday showed that the number of Americans who applied for unemployment benefits in late October fell to yet another pandemic low, reflecting an urgent need by companies to hold on to current employees and find new ones. New jobless benefit claims dropped by 14,000 to 269,000 for the seven days ended Oct. 30.

Meanwhile, labor costs surged in the third quarter due to higher wages and production snafus, as U.S. productivity sank at a 5% annual pace. And the U.S. trade deficit widened to a new record high.

What are analysts saying?

“Traders who positioned for escalating rates in both the euro zone and England are now pulling back, and when something that fast happens in smaller government markets, some of that spills over into Treasuries,” said Jim Vogel of FHN Financial. “They are taking the Fed out of the top tier of headlines.”

The fact that the shift to Fed tapering “took place with 10-year yields failing to move above 1.60% reinforces the notion that the onus will be the performance of the real economy and the ultimate impact on Fed policy to drive the next durable trend in Treasuries,” BMO Capital Markets strategist Ben Jeffery wrote in a note.

Whether the Fed has missed the boat on inflation is “a question we’re all asking,” said John Farawell, executive vice president and head trader with bond underwriter Roosevelt & Cross in New York. The October nonfarm payroll report released Friday “could be really significant because it would give us a signal about whether a lack of more people coming back into the labor force will mean wages go up and get passed on to consumers.”

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