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U.S. Treasury Yields Retreat, Stocks Gain On Fading Fed Rate Hike Bets

Traders are paring bets on a Fed rate hike even as data continues to point to a stronger-than-expected post pandemic recovery for the world's biggest economy.

U.S. Treasury bond yields tested two-week lows Tuesday as investors pared bets on Federal Reserve rate hikes even as data continues to point to a surging post-pandemic recovery that could stoke near-term inflation. 

Benchmark 10-year Treasury yields were last seen trading at 1.659%, the lowest since March 26 and some 10 basis points south of the January 2020 high they reached early last week. Yields on 2-year notes, which touched an 18-month high yesterday, eased to 0.163% as the dollar extended declines against its global currency peers and traders faded rate hike bets.

The CME Group's FedWatch tool, which indicated a 15% chance of a December rate hike yesterday, is now suggesting less than a 5% probability, partly in the wake of comments from Cleveland Fed President Loretta Mester, who told CNBC Monday that the central bank is "still far from our policy goals" and needs to be "very deliberately patient in our approach to monetary policy."

U.S. stocks extended gains as Treasury yields retreated, with the Dow Jones Industrial Average rising to a fresh all-time high of 33,543.1 points and the S&P 500 moving to 4,804.60 points. Rate-sensitive tech stocks were also active, reversing earlier losses to lift the Nasdaq Composite index 48 points, or 0.35% higher by mid-day trading in New York.

The pullback in both rate hike bets and inflation forecasts is somewhat confusing, given that last week's non-farm payroll release showed that U.S. employers added 916,000 new jobs last month - a figure that is expected to top more than 1 million each month throughout the spring as vaccine rollouts accelerate and states continue to re-open non-essential businesses.

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The Institute for Supply Management's closely-watched reading of the services sector, the biggest and most important component of the domestic economy, showed the best growth on record in March and bullish forecasts from the country's business leaders.

However, in both the employment data -- which showed a month-on-month decline in average hourly earnings -- and the cost increases that lifted the 'prices paid" index inside the ISM reading was mostly attributed to supply-chain issues and semiconductor shortages that will fade throughout the second half of the year. 

In fact, Bank of America's weekly "Flow Show" report indicates the strongest macro backdrop since the Second World War, based on what it describes as "epic Keynesian stimulus" in the U.S. of around $4 trillion and the likelihood of subdued near-term inflation.

A record $372 billion in new money was plowed into global stocks over the first quarter, the report noted, with another $48.6 billion added over the holiday-shortened Easter week. 

However, Manoj Pradhan of Taking Heads Macro, and Morgan Stanley's former global head of economics, thinks markets are underestimating inflation risks.

“Inflation in the US could peak at around 3%, but there is still some complacency it is going to fall, and this risk needs to be challenged," he said. "“Increased inflation will mean the yield curve steepens and attempts to control it will push inflation even higher, with the result that asset returns will be harder to extract."