U.S. government debt has reversed its early-year rally, sending Treasury yields higher than where they finished 2022. That is threatening to end a brief reprieve for stocks and riskier types of bonds, which both languished last year as yields climbed rapidly.

The yield on the benchmark 10-year Treasury note has raced back toward 4% over the past month, a level it hit last year for the first time since 2008. It finished Tuesday at 3.953%, well above its 3.374% January low and higher than the 3.826% where it ended 2022. Yields rise as bond prices fall.

Blame traders' fast-changing expectations for how the Federal Reserve might respond to new data suggesting the economy isn't cooling. The shift has forced a reappraisal of the so-called terminal interest rate, the level at which the Fed will stop hiking further.

Derivatives markets show traders now expect the terminal rate this summer to be above 5.25%. A month ago, they were betting on a peak rate of about 4.9%. The Fed's rate target currently stands at 4.5% to 4.75%.

"As we got nearer to the terminal rate, the market had been saying, 'Job done, I can be comfortable with the Fed's rate path,'" said Matt Smith, investment director at London-based Ruffer LLP. "That's reversed in the last two or three weeks because the data coming through is saying the economy's still going strong."

Ruffer's flagship fund has reduced its exposure to long-term government debt, he said.

As they were for much of last year, investors are once again hanging on any indication of how the Fed will respond to a stronger-than-expected economy. On Wednesday, the release of minutes from the Fed's latest meeting may shed light on how officials were considering the path forward at the start of this month.

But traders could face continued uncertainty heading into the central bank's late March meeting, when Fed officials are expected to update their projections for future interest-rate decisions, said Jim Vogel, manager of interest-rate strategies at FHN Financial.

"What happens if the dots for future years start going up?" Mr. Vogel said, referring to the Fed's interest-rate forecasts. Investors may think, "I thought the Fed was trying to kill inflation, but what if they also wind up restraining growth?" he added.

Rising Treasury yields erode investors' willingness to pay up for stocks and corporate bonds, because buying Treasurys lets investors lock in attractive returns that are practically guaranteed. The broad-based S&P 500 index has lost ground for two straight weeks, shedding a portion of its year-to-date gains. Yields on corporate bonds have climbed, signaling higher borrowing costs for companies.

"Suddenly, if you're holding stocks, you need more out of that asset," said Steve Foresti, senior adviser at Wilshire Associates. "Capital wants to flow to these higher yields."

After raising interest rates by three-quarters of a percentage point at four straight meetings last year, the central bank downshifted to a half-percentage-point increase in December, and followed that with a quarter-point rise in February. Coming into this year, many investors assumed that declining inflation and a slowing economy would give the Fed the go-ahead to ease off.

Strong data have now rejiggered that assumption. Last week, inflation figures for January came in higher than expected and showed a decelerating pace of decline compared with previous months. That followed the latest employment report earlier this month, which indicated unemployment has fallen.

Data such as those have boosted growth expectations. The Atlanta Fed's model now projects real gross domestic product will grow by 2.5% in the first quarter, up from an estimated 0.7% a month ago.

At that point, Wall Street had practically ruled out the possibility that the Fed could reaccelerate its rate increases with a half-point increase in March. Now, bets in fed-funds futures markets show traders' giving that outcome one-in-four odds after a pair of Fed officials discussed a more hawkish approach last week. Bank of America economists have added an additional June rate increase to their projections for the Fed's next moves.

The shift has once more boosted government-bond yields, which are closely tied to investors' expectations for how the central bank will set interest rates. The two-year Treasury yield, especially sensitive to near-term Fed policy expectations, finished Tuesday at 4.729%, up from a recent mid-January low at 4.076%.

Higher yields drive up borrowing costs for everyone from home buyers seeking mortgages to businesses raising funds for expansion projects.

Last week, U.S. mortgage rates marked their fastest increase in four months, rising again to 6.32% after mostly falling since mid-November. New data Tuesday showed existing-home sales fell in January for the 12th straight month.

Meanwhile, the all-in yield on investment-grade corporate bonds, which represents business borrowing costs, has climbed to 5.41%, from 4.95% at the beginning of February, according to index data from Intercontinental Exchange Inc.

Tighter financial conditions such as those, in theory, support the Fed's goal of cooling down the economy to tame inflation. But in considering how to proceed, central bankers must also make their best guess about how long it will take for interest-rate increases already enacted to take their full effect.

Treasurys' rapid selloff may have brought some bond prices below their fair value, FHN's Mr. Vogel said. The five-year Treasury yield finished Tuesday at 4.173%, which looks high considering that Fed officials have projected that interest rates will fall to around 3% by the end of 2025, he said. In general, however, yields are now reflecting more reasonable assumptions about the Fed's plans than they were a month ago, Mr. Vogel said.

"People were thinking 'Oh my gosh, maybe we missed the opportunity to buy higher yields,' and that created a miniature stampede into the market," he said. "Now we have more balance."

Questions

1 Why have bond yields increased recently?
2 Why have revised expectations regarding interest rates negatively impacted stock prices?
3 Why do tighter financial conditions support the Fed's efforts to tame inflation?

Answer rating: 100% (QA)

1 Bond yields have increased recently due to changing expectations about how the Federal Reserve Fed ... View the full answer