Pressure on beaten-down U.S. bonds is showing few signs of relenting, driving Treasury yields to new highs and threatening further pain across financial markets.
With bond investors already confronting their worst returns in living memory, Treasury yields kept on climbing last week in response to more bad news on inflation, stubbornly strong economic-activity data and continuing turmoil in overseas markets. Yields rise when bond prices fall.
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Pressure on beaten-down U.S. bonds is showing few signs of relenting, driving Treasury yields to new highs and threatening further pain across financial markets.
With bond investors already confronting their worst returns in living memory, Treasury yields kept on climbing last week in response to more bad news on inflation, stubbornly strong economic-activity data and continuing turmoil in overseas markets. Yields rise when bond prices fall.
By the end of Friday, the yield on the benchmark 10-year U.S. Treasury note was 4.005%. That marked its 11th straight week of gains and first time it had closed above 4% since October 2008, around the height of a financial crisis that ushered in a new era of ultralow interest rates. The yield edged up to 4.012% Monday.
Tumbling bond prices and surging yields have hurt not only bonds but stocks this year. The ability to earn a better forward-looking return on Treasurys—which are seen as essentially risk-free if held to maturity—has caused a sharp decline in the prices that investors will pay for riskier assets.
The big problem for investors is that the forces that have battered bonds all year aren’t obviously easing, even as additional challenges mount.
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Last Thursday’s consumer-price index report joined a recent litany showing inflation being even hotter than economists had expected. That drove investors to once again lift their expectations for how high the Federal Reserve will raise its benchmark interest rate—the trajectory of which plays a decisive role in determining the level of Treasury yields.
Investors, meanwhile, have been encouraged by moves by the U.K. government to reverse most of its proposed tax cuts—the source of a huge selloff in U.K. bonds that has sent shock waves globally. But they remain generally nervous about foreign demand for Treasurys, as interest rates rise sharply overseas, potentially drawing money away from the U.S.
“The fundamental issue is still one of unprecedented tightening by central banks, as a response to inflation and the fact that inflation is broad-based [and] persistent,” said Priya Misra, head of global rates strategy at TD Securities in New York.
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Investors have already made a historic adjustment to their interest-rate bets.
Coming into 2022, most Wall Street banks and investors believed that the Fed would raise its federal-funds rate no more than three times, in traditional 0.25 percentage point increments, to around 0.75% by the end of the year. Now, that rate is above 3%, and interest-rate derivatives show that investors believe that there is a meaningful chance it could reach 5% by March.
Investors’ expectations for the so-called terminal fed-funds rate are especially important for shorter-term Treasurys, such as two-year notes, since the Fed is likely to leave rates at that level for at least several months.
The anticipated terminal rate, however, still powers moves in longer-term Treasurys such as the 10-year note, which tend to have a larger impact on household and business borrowing costs.
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Given the high probability of a recession and rate cuts in the next decade, shorter-term yields are currently higher than longer-term yields. Nonetheless, many analysts say, it could be hard for that gap to expand much further, because investors are generally reluctant to buy lower-yielding bonds when they can own higher-yielding ones.
Illustrating this point, the two-year note went from yielding 0.9 percentage point less than the 10-year note in early January to yielding 0.5 percentage point more in early August, according to Tradeweb. Since then, however, the additional yield on the two-year note hasn’t increased even as interest-rate expectations have climbed substantially.
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For investors, that means a major debate remains about where interest rates will peak, regardless of what happens afterward.
Treasury yields, more than the fed-funds rate, help determine borrowing costs across the economy. Forecasting the terminal fed-funds rate, therefore, requires determining whether current yields are sufficient to tame inflation, or whether Fed officials will start to project even higher rates to tighten financial conditions further.
Humbled by recent experience, many investors are prepared for the latter outcome, implying an extension of the turmoil in both bond and stock markets.
One reason is recent economic data, which have provided minimal evidence that either economic growth or inflation is subsiding.
As of Friday, a closely watched economic model run by the Federal Reserve Bank of Atlanta suggested that real U.S. gross domestic product grew at a 2.8% pace in the three months ended Sept. 30, a substantial uptick over the previous quarter. According to the Labor Department, core consumer prices rose 0.6% in September from the previous month—keeping annualized inflation far above the Fed’s 2% target.
There is a real risk that the fed-funds rate doesn’t “peak at 5—maybe it’s 5.5, maybe it’s a bit beyond that, and that would be because inflation is enduring, and that’s because consumer spending is holding up and that’s because the labor market is still too strong,” said Christopher Sullivan, chief investment officer at the United Nations Federal Credit Union.
Mr. Sullivan said he has remained conservative in the funds he manages, protecting against the risk of rising yields by investing more in cash and floating-rate debt.
Still, other investors say Treasury yields are attractive at current levels, arguing that current economic data can be misleading because of the lagged effects of monetary policy. Any stabilization in yields would help support equities, leaving stock prices to be mainly dictated by the outlook for corporate earnings.
The Fed is doing a lot, but “all of this takes time to make its way into the inflation figures,” said Pramod Atluri, a fixed-income portfolio manager at Capital Group.
Mr. Atluri said bond prices could decline in the near term as the inflation outlook remains uncertain but should rebound over the next 12 months.
The Fed, he added, is unlikely to raise rates much above 5%, but if it did signal that it was moving there, it would likely deepen recession fears, keeping longer-term yields relatively anchored.
Write to Sam Goldfarb at sam.goldfarb@wsj.com