Analysis-Investors see no let-up in bond market strain 

By Gertrude Chavez-Dreyfuss

NEW YORK, May 19 (Reuters) – The latest sharp selloff in U.S. Treasuries may be far from over.

A combination of stubborn inflation, shifting expectations about interest rates, and changes in investor behavior could keep pressure on bond prices and drive yields even higher in the weeks ahead, analysts said.

For months, many investors have viewed the 4.5% yield on the benchmark 10-year note as an attractive point to step in and buy bonds. But as yields surged through that level, market participants adjusted their view of where buyers would next bite.

“The question going forward is: will guys really buy here because I believe this (selloff) will continue to persist,” said Padhraic Garvey, head of global rates and debt strategy at ING.

“We’re probably headed to 4.75% in the next round,” he added, citing several underlying forces that continue to fuel the selling. The 10-year yield was last at 4.62%.

Rising benchmark yields pose a challenge for U.S. stocks, as higher borrowing costs weigh on companies and consumers.

A key driver, however, remains inflation: recent consumer and producer price data have come in stronger than expected, reinforcing the view that price pressures are not easing as quickly as markets had hoped. With more data due, particularly for May, analysts expect inflation to stay elevated.

If bond investors believe inflation will stay high—or even rise further—they would demand higher yields to compensate for the loss in purchasing power.

Market-based measures of long-term inflation expectations, or so-called breakevens, rose to 2.507% on the benchmark 10-year note on Friday, close to a three-year high. Breakevens reflect, in part, investor confidence in the Federal Reserve’s ability to rein in inflation over time.

ING’s Garvey warned that even a small increase in inflation expectations—to around 2.6% or 2.7%—could push yields noticeably higher. “That’s how you get the next 10, 20, 30 basis points into the upside in yields very easily.”

This suggests that the market may not have fully priced in the risk of sustained inflation yet. Investors are now beginning to consider the possibility that the Federal Reserve could hold rates steady for longer, or even raise them if inflation does not ease.

As investors adjust to the idea that rate cuts are off the table, short-term yields have moved higher.

Jim Barnes, director of fixed income at Bryn Mawr Trust, said the mood in the market has clearly changed. “It’s a different interest rate environment.”

“In the absence of any positive news on Iran and combined with data pointing toward inflationary pressures, it’s as if the bond market just threw up its hands and just said we have to reprice the market higher.”

LONG-END WOES; FOREIGN TREASURY BUYERS

At the long end of the Treasury curve, the picture also looks uncertain.

Guneet Dhingra, head of U.S. rates strategy at BNP Paribas, said once 30-year Treasury yields moved above 5%, they effectively lost a clear ceiling. In the past, certain levels tended to act as barriers, but once broken, yields can move more freely.

“Now that we have no anchor, what stops bond yields from going up in a world of high inflation, ever-rising deficits, and global bond yield pressure?” said Dhingra.

At the same time, an important factor is the composition of Treasury buyers. In the past, large foreign buyers—such as countries with trade surpluses with the United States—were steady purchasers that were less sensitive to short-term market moves.

Today’s buyers are markedly different and more price-sensitive, Dhingra said, often based in financial centers such as those from the United Kingdom, Belgium, the Cayman Islands and Luxembourg. These countries serve as major custody hubs of Treasuries for various hedge funds around the world, and are in the top seven largest non-U.S. holders of Treasuries.

The UK overtook China in March last year as the second-largest owner of U.S. government debt, and now holds nearly $900 billion in Treasuries.

This shift means that higher yields don’t automatically bring in buyers the way they once did, Dhingra said. Investors are more cautious and selective, which can allow yields to rise further before demand picks up — potentially testing higher levels before finding a lasting floor, he said.

“We’re not finished yet. We’re just in May and inflation rates will be higher,” said ING’s Garvey.

(Reporting by Gertrude Chavez-Dreyfuss; editing by Megan Davies and Aurora Ellis)