The 1-year Treasury yield spiked by 16 basis points, to 4.0%, highest since July, three rate cuts ago, as the bond market now expects multiple rate hikes.

By Wolf Richter for WOLF STREET.

The US government sold $518 billion of Treasury securities during the week: $477 billion of Treasury bills, spread over six auctions, with maturities from 4 weeks to 26 weeks, most or all of them to replace maturing T-bills; and $41 billion of Treasury notes and bonds spread over two auctions (5-year Treasury Inflation Protected Securities and 20-year Treasury bonds).

This was also the week of the first FOMC meeting under Fed Chair Kevin Warsh, when the extent of the “regime change” at the Fed became apparent  in the FOMC statement, in the FOMC Implementation Notes – which opened the path for the Fed to end its Reserve Management Purchases of T-bills – and in the press conference, where he laid out the focus of his five “taskforces.” In response, 6-month to 2-year Treasury yields spiked.

The 1-year Treasury yield spiked by 16 basis points on Wednesday and Thursday to 4.0%, the highest since July last year, three rate cuts ago. Since early February, it has surged by 60 basis points and is now 37 basis points above the Effective Federal Funds Rate (EFFR, blue line) which the Fed targets with its policy rates.

Treasury yields of 1 year and shorter are boxed in by the Fed’s policy rates and by market expectations of those policy rates within their remaining maturity window. By pushing the 1-year yield up like this, the bond market has begun to price in a second rate hike within the window of the 1-year Treasury yield.

The 6-month Treasury yield spiked by 10 basis points on Wednesday and Thursday to 3.90%, the highest since September 2, three rate cuts ago.

It is 27 basis points above the EFFR, a sign the bond market has more than fully priced in one rate hike by yearend.

But the auction of the 6-month (26-week) Treasury bill took place on Monday, two days before the drama of the FOMC meeting when Warsh detailed his regime change, and therefore two days before the spike of the yield in the secondary market, and so the auction yield was actually a hair lower than at the auction a week earlier.

Type	Auction date	Billion $	High Rate	Investment Rate
Bills 4-week	Jun-18	74	3.58%	3.64%
Bills 6-week	Jun-16	70	3.60%	3.67%
Bills 8-week	Jun-18	80	3.64%	3.71%
Bills 13-week	Jun-15	96	3.64%	3.73%
Bills 17-week	Jun-17	73	3.67%	3.77%
Bills 26-week	Jun-15	83	3.68%	3.80%
Bills		478

“High rate” and “Investment Rate” are the two different calculations of the yield that the Treasury Department provides with its T-bill auction results. T-bills are sold at a discount, and at maturity, the holder gets paid face value; the difference is the interest. There are no coupon interest payments. The “high rate” reflects the yield calculation of that process.

To make this discount yield comparable to the yields of coupon securities (2-year to 30-year), the Treasury Department re-calculates it as “investment rate,” which is higher than the “high rate.” And around the time of the auction, the “investment rate” is close to the “constant maturity yield” published by index providers to reflect trades in the secondary market for that type of remaining maturity.

But these T-bill yields are still negative in real terms, despite the spike – all of them are still below the rate of CPI inflation which has accelerated to 4.25%. But as rate hikes are being priced into these yields, they’re chasing after inflation from below.

The yield of the 2-year Treasury notes spiked by 14 basis points on Wednesday and Thursday to 4.19%, the highest since February last year.

This longer-term view of the 2-year yield shows just how significant the directional change of short-term interest rates has been, going from two years of rate-cut mode into full-blown rate-hike mode, and the Fed has made no attempt to fight the bond market on it, but has been going along with it.

The US government also sold $41 billion of Treasury notes and bonds this week, spread over two auctions: 5-Year TIPS and 20-year Treasury bonds.

Notes & Bonds	Auction date	Billion $	Auction yield
TIPS 5-year	Jun-18	28	*1.955%
Bonds 20-year	Jun-16	13	4.93%
Notes & bonds		41

*TIPS yield is paid on top of the inflation protection that TIPS holders receive. This inflation protection is based on CPI and is added to the principal, and so the principal of the TIPS grows over time with CPI. The coupon interest rate is fixed for the term of the TIPS, and is applied to the entire principal, including the inflation protection. As the principal grows over time with CPI, the coupon interest payments increase, though the interest rate of the coupon remains fixed.

The 5-year TIPS sale was marked by a big difference between the coupon interest rate of 1.25% and the yield established at the auction of 1.995%, which caused the TIPS to be sold at a substantial discount: The unadjusted price was $96.79 per $100 of face value.

This difference between coupon interest rate and yield occurred because this was a “reopening” auction of a TIPS issue that was originally sold in April. Both auctions sold the same issue of TIPS with the same CUSIP number (91282CQP9), the same maturity date (April 15, 2031), and the same coupon interest (1.25%). At the time, the 5-year TIPS went through the auction at a yield of 1.367%. But yields have shot up since then. And the same issue of TIPS went through the auction this week at a yield of 1.955%. To get there, the price was established at the auction at a substantial haircut, and the investors who’d bought two months earlier got a worse deal. But those are the adventures in bondland.

Reopening auctions are routine, including for 10-year notes; each 10-year note issue has one original auction and two reopening auctions. So there are only four 10-year note issues per year (four CUSIP numbers), spread over 12 auctions. There are only two 5-year TIPS issues per year (two CUSIP numbers) spread over four auctions. This system increases the size of each issue of securities and thereby the liquidity in the secondary market of each issue.

The 5-year TIPS yield had gone massively negative during the time of the interest-rate repression by the Fed through its QE programs. For example, the 5-year TIPS issue that matured on April 15, 2026, was sold at auction in April 2021 with a coupon interest of 0.125%, but the price was bid up during the auction to $109.11 per $100 of face value, which caused the yield to be negative -1.631%. These TIPS holders paid $109.11 for each $100 in face value but then received the inflation protection during those five years, plus the $100 in face value, plus the coupon interest payments of 0.125% on the face value plus inflation protection.

QE had driven the 5-year TIPS yield deeply into the negative, starting in August 2010. With the beginning of QT in late 2017, the TIPS yield emerged from the negative in a significant way. Then in March 2020, under mega-QE, it re-plunged into the negative. In June 2022, after QE had ended and on the cusp of QT, it re-emerged from the negative.

The 10-year Treasury yield declined 7 basis points during the week to 4.46% as falling oil prices have eased off pressure on fears of inflation blowing out. All the hoopla this week about a deal with Iran played into that. That longer end of the bond market dances to fears and hopes about the imagined path of inflation and the oncoming supply of Treasuries to fund the ballooning deficits that the market has to absorb and that may require higher yields to attract ever more investors.

Compared to the years before QE, before 2009, the 10-year yield at this level is still relatively low. And compared to 4.25% CPI inflation, the 10-year yield at 4.46% is very low. Clearly at this point the bond market still thinks inflation will go back somewhere near 2%.

If the Fed raises its inflation target from 2%, the bond market would then have to finally give up its hopes for a return to 2% inflation, and yields would likely adjust to it. Raising the official inflation target to 3% could push the 10-year yield to 5.5%.

Higher bond yields in the market mean lower bond prices for existing holders, and vice-versa.

The 30-year Treasury yield declined by 7 basis points during the week to 4.91% on Thursday, on all the hoopla about the Iran deal.

The long-term Treasury yields completely blew off the Fed’s rate cuts. But the end of QE in early 2022 and the start of QT in the second half of 2022 allowed those long-term yields to rise. My imaginary trend line connecting some of the lows of the past three years still holds:

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