A Big Bond Rally Is Promising Some Help for Home Buyers

Signs of cooling inflation have driven a furious bond rally this month, boosting stocks to records and promising to inject some life into the listless housing market.

The sharp rise in bond prices has pushed down the yield on the 10-year U.S. Treasury note by nearly a half percentage point since late May. The yield on Friday notched its largest two-week decline of the year, settling at 4.212%.

A benchmark for mortgage rates and other borrowing costs across the economy, the 10-year yield is heavily influenced by investors’ expectations for short-term interest rates set by the Federal Reserve. Still, investors’ renewed appetite for bonds was barely slowed last week when the Fed suggested it would be cautious about cutting rates in the coming months.

Of the 19 officials who submitted interest-rate projections last Wednesday, the median forecast was for just one rate cut this year. That was down from their forecast in March for three cuts, and fewer than the two-cut projection that many analysts thought was possible.

For investors, however, the Fed’s outlook didn’t matter as much as a run of economic data that has bolstered hopes that inflation is easing again and back on track to reach the central bank’s 2% target.

Futures markets Friday showed investors think there is a better than 70% chance that the Fed will cut rates at least twice this year, with the first cut most likely happening in September, according to CME Group data. That was double the chances seen in late May.

Recent evidence has indicated that a streak of surprising price jumps during the first few months of the year “was more an aberration than a break in the trend of inflation moderating,” said Andrzej Skiba, head of U.S. fixed income at RBC Global Asset Management.

That has given investors the confidence to bet on rate cuts, especially since the Fed released its forecasts just hours after an encouraging consumer-price index report. Many officials might have been reluctant to change their predictions at the last minute, Skiba said.

If sustained, the relatively steep decline in Treasury yields could have major implications for markets and the economy.

Higher yields can hurt stocks by driving up borrowing costs for businesses and consumers and threatening to slow the economy. They can also make stocks look less attractive by giving investors a higher return for holding risk-free government bonds to maturity.

Stocks have managed to defy rising bond yields for much of this year, fueled in part by investor excitement about artificial intelligence. Even so, they have repeatedly hit rough patches when the 10-year yield has climbed especially high.

The S&P 500 fell 4.2% in April, after stubbornly hot inflation pushed the 10-year yield above 4.5%. The index also edged lower in the second half of May when the 10-year yield climbed back above that threshold. It is now up 2.9% in June, with the benchmark yield retreating.

Even modest fluctuations in Treasury yields can have a serious impact on the housing market.

After mortgage rates declined along with 10-year yields at the end of last year, for example, sales of existing homes climbed to an annual rate of 4.38 million in February, from 3.85 million in October, according to the National Association of Realtors. Sales then declined again when 30-year mortgage rates climbed back above 7%.

Given the volatility in yields since the Fed started raising rates in early 2022, some investors caution they could easily rise again, making any relief for prospective home buyers fleeting.

At the start of the year, investors were brimming with confidence about the outlook for rate cuts after a string of good inflation reports. Then they got a rude awakening when progress stalled over the next three months.

A resilient economy could also reduce the Fed’s urgency to cut rates even if inflation does continue to moderate.

Investors have recently been pleased by signs that the labor market is cooling, a trend that should make it easier for inflation to keep falling. Despite robust job growth, the unemployment rate ticked up to 4% in May from 3.4% in the middle of last year. Job openings have also declined sharply, as has the number of workers voluntarily leaving their jobs in pursuit of new ones.

Still, none of this has generated much concern among investors that the economy is losing too much momentum, given how historically tight the labor market was not that long ago, said Vishal Khanduja, a fixed-income portfolio manager at Morgan Stanley Investment Management.

He said demand for workers likely needs to ease even further for the economy to fully normalize.

Some investors, though, are betting that yields can keep dropping.

Regardless of when the Fed starts cutting interest rates, traders are wagering the central bank will eventually stop once they reach about 4%, from their current target range of 5.25% to 5.5%, said Ed Al-Hussainy, senior interest rates and currency analyst at Columbia Threadneedle.

That would mean the economy could withstand much higher rates than what was in place before the Covid-19 pandemic hit in 2020. But Al-Hussainy said he is increasingly skeptical.

“If the labor market is returning to a place that kind of looks like pre-Covid, it will be very unusual for rates to not be aligned with that,” he said.

Write to Sam Goldfarb at [email protected]