U.S. Treasuries sell off amid Fed tough talk, growing de-risk mood



By Herbert Lash

NEW YORK, Sept 29 (Reuters) - U.S. Treasuries resumed a sell-off on Thursday as Federal Reserve officials reaffirmed the U.S. central bank's plans to tame inflation by aggressively hiking interest rates, an outlook that deepened a risk-off mood in capital markets.

Markets are in flux after the new British government's plans last week to drive growth through huge tax cuts sent bond yields higher and caused the pound to plunge. The turmoil further unsettled investors already concerned about inflation and rising rates.

"The markets are pretty fragile here at this point," said Tom di Galoma, managing director at Seaport Global Holdings LLC.

"People are really worried about liquidity and liquidity in pretty much all markets, whether it's forex, whether it's swaps or rates, and it's playing into the credit market," he said.

With the war in Ukraine raging and winter fast approaching, investors are trying to de-risk portfolios as the third-quarter ends and the fourth quarter begins, di Galoma said.

Any hope that a more accommodative path to tackling inflation might be in store was not apparent from Fed officials.

Cleveland Fed President Loretta Mester said she does not see distress in U.S. financial markets that would alter the central bank's campaign to lower inflation through rate hikes that have taken the fed funds rate to a range of 3.0% to 3.25%.

Mester told CNBC that she still sees inflation as the paramount problem facing the U.S. economy, which means the Fed needs to press forward with hiking rates to lift the federal funds target rate to over 4%.

"We're not at a point where we should think about stopping on rate hikes," Mester said. "We're still not even in restrictive territory on the funds rate."

St. Louis Fed President James Bullard said rates will probably need to be "higher for longer" than markets previously anticipated and that a sharp downtown was not envisioned.

"We are at higher recession risk, but that's not the base case at this point," Bullard told reporters on a conference call.

The two-year US2YT=RR Treasury yield, which typically moves in step with rate expectations, was up 8.6 basis points at 4.180%, while the yield on benchmark 10-year notes US10YT=RR rose 5.4 basis points to 3.761%.

The 10-year's yield on Wednesday fell 25.6 basis points to 3.707%, its biggest single-day drop since March 2009 in reaction to the Bank of England's intervention to halt the plunge in bonds and sterling's weakening.

The BoE said it would buy long-dated gilts to restore financial market stability, a move that could lead the Fed to halt its balance sheet reduction to avert a hard U.S. landing, said Joe LaVorgna, chief U.S. economist at SMBC Nikko Securities in New York.

The Fed is reducing its balance sheet by $60 billion of Treasuries every month, which is drying up liquidity. By stopping the runoff, rates could go higher and faster, in line with Fed plans to quickly stanch inflation, LaVorgna said.

"It seems to me the Bank of England may have a little bit of a template on how in the Fed's mind it may be able to get the funds rate higher," he said.

"It is conceivable the Fed could take the playbook out of BoE, the playbook in that in light of market conditions we're either going to slow or temporarily pause on balance sheet reduction," LaVorgna said.

The gap between yields on two- and 10-year Treasuries US2US10=RR , seen as a recession harbinger, steepened at -42.1 basis points.

The 30-year yield US30YT=RR was up 1.9 basis points to 3.700%.

The breakeven rate on five-year U.S. Treasury Inflation-Protected Securities (TIPS) US5YTIP=RR was last at 2.234%.

The 10-year TIPS breakeven rate US10YTIP=RR continued to decline and was last at 2.184%, indicating the market sees inflation averaging just under 2.2% a year for the next decade. The rate has fallen from about 2.64% five weeks ago.

The U.S. dollar five-years forward inflation-linked swap USIL5YF5Y=R , seen by some as a better gauge of inflation expectations due to possible distortions caused by the Fed's quantitative easing, was last at 2.256%.

Sept. 29 Thursday 3:56 PM New York / 1956 GMT

Price

Current Net

Yield % Change

(bps) Three-month bills US3MT=RR

3.255

3.3273

-0.047 Six-month bills US6MT=RR

3.7775

3.9041

-0.014 Two-year note US2YT=RR

100-34/256 4.1801

0.086 Three-year note US3YT=RR

98-20/256

4.1971

0.075 Five-year note US5YT=RR

100-146/256 3.998

0.076 Seven-year note US7YT=RR

99-216/256 3.9007

0.076 10-year note US10YT=RR

91-184/256 3.7614

0.054 20-year bond US20YT=RR

91-108/256 4.0048

0.020 30-year bond US30YT=RR

87-104/256 3.7

0.019

DOLLAR SWAP SPREADS

Last (bps) Net

Change

(bps)

U.S. 2-year dollar swap spread

29.00

-2.00

U.S. 3-year dollar swap spread

7.25

-0.75

U.S. 5-year dollar swap spread

4.75

-0.25

U.S. 10-year dollar swap spread

4.50

-0.25

U.S. 30-year dollar swap spread

-41.75

-0.75


Reporting by Herbert Lash Editing by Nick Zieminski, Leslie Adler and Jonathan Oatis

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