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The bond market is shaky between fears of debt default and high-interest rates

The bond market is exhibiting signs of fear and incertitude these days. Indeed, bond traders are losing faith that the Federal Reserve is done tightening monetary policy and will rise to the rescue with rate cuts this year. This is because, during the last Fed meeting, Jerome Powell left the option to perhaps hike rates again in the next Fed meeting, if after assessing economic data, the economy does not show any sign of slowing demand.

The bond market in recent days has been pulled between those poles—of a surprisingly resilient economy and a political standoff in Washington that threatens to deal it a major blow. Until Friday, when debt-ceiling negotiations hit a roadblock, traders were squarely focused on the growing risk of still-higher rates as central banks warned that the job of beating inflation is far from over and data showed the economy is growing at a faster-than-expected pace.

The market rallied strongly in March on speculation that bank failures would usher in several rate cuts by the end of the year. But with the turmoil in that industry subsiding, those expectations have shifted. Traders were recently pricing in roughly two quarter-point cuts by December and an approximately 25% chance of an increase at the June meeting.

The strength of the economy will almost certainly take center stage if President Biden’s administration and Republicans in Congress reach a deal to raise the debt limit, removing the risk of an unprecedented debt default that would roil global markets. Treasury yields have climbed to levels not seen since mid-March, with the 2-year tenor climbing as high as 4.35%--up from as low as 3.55% in late March—before paring the jump after the discussions in Washington faltered. The 10-year yield reached as much as 3.72% this week, also the highest in more than two months. Thus, the risk now for bulls is that the market would be hit by another selloff if data doesn’t soon begin to flag that the economy is slowing enough to bring down still-elevated inflation.


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