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Fed's Dudley Pushes Two-Year Yield to Near a 2017 High

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06/19/2017 | 10:08pm CET
By Min Zeng 

The yield on the two-year Treasury note rose to the highest level in more than three months and approached its 2017 high on Monday after a top Federal Reserve official suggested that a third rate increase this year remains on the table.

Yields on short-term Treasury debt are highly sensitive to the Fed's rate policy outlook. The yield on the two-year Treasury note settled at 1.364%, compared with 1.319% Friday. The yield marked the highest close since March 14 when it settled at 1.380%, the highest close since June 2009.

Yields rise as bond prices fall.

The yield on the benchmark 10-year note was 2.188%, compared with 2.157% Friday.

Investors sold Treasury debt after New York Federal Reserve President William Dudley held an upbeat assessment over the economy, suggesting that reports of slowing inflation haven't caused any worries. Mr. Dudley said he was "very confident" that there is "quite a long ways to go" in the economic expansion, already the third-longest in U.S. history.

His remarks followed the Fed's decision last week to raise short-term interest rates. Fed officials stuck to their projections of an additional rate increase in 2017 and three more in 2018, even as some investors expect slowing inflation to derail the Fed's plan.

"Dudley's message to the bond market is that the Fed sticks to its rate-hike plan," said Edward Fitzpatrick, portfolio manager at J.P. Morgan Asset Management.

Mr. Fitzpatrick said he expects the two-year yield to rise to between 1.625% and 2% at the end of this year if the Fed raises rates again later this year.

In the years past, Mr. Dudley and Fed Chairwoman Janet Yellen were considered by investors as strong doves in the Fed circle as they had been leading advocates that the U.S. economy needs support of ultraloose monetary stimulus. Their stance on monetary policy appeared to be less dovish than before. Ms. Yellen surprised many investors last week when she didn't blink on the soft inflation data.

But the selling pressure following last week's Fed meeting has been mild in the bond market. The 10-year yield remains near its 2017 closing low of 2.138%, set last Wednesday. For the year, the yield has been down from 2.446% at the end of 2016.

The decline of long-term bond yields, with its yield premium relative to the two-year note last week falling to the lowest since last September, reflects some investors' concerns that the Fed's pace of rate increases may uncut the economic growth momentum. Anxiety has been rising lately whether the Fed may make a policy error by tightening policy with inflation readings falling below the central bank's 2% target again.

"It is a fairly significant vote of no confidence in the Fed's policy and inflation forecast," said Ethan Harris, head of global economics research at Bank of America Merrill Lynch.

Derivatives markets linked to the Fed's policy are showing skepticism toward the Fed. Fed-fund futures, a popular derivative market for hedge funds and money managers to bet on the Fed's policy outlook, suggested 46% odds that the Fed would raise rates again by its December 2017 meeting, according to CME Group. The probability was 41% on Friday.

The New York Fed's model projected Friday a 1.9% growth rate for the world's largest economy during the second quarter, down from 2.3% in an earlier forecast.

Some investors say the Fed may be forced to stand pat later this year if further data show disappointing growth or more deceleration in inflation. Ms. Yellen said last week that monetary policy isn't on a preset course, signaling her flexibility in the tightening plan.

Bond buyers may be vulnerable if the Fed gets it right on their assessment over growth and inflation, say some traders. In this case, selling may hit the bond market as investors readjust their expectations over the Fed's tightening pace.

Write to Min Zeng at [email protected]

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