By Gertrude Chavez-Dreyfuss
NEW YORK, Sept 14 (Reuters) - A global bond market in turmoil is likely to face a Federal Reserve rate hike this week that would boost borrowing costs and slow the economy. But many investors warn the bigger problems could lie ahead should the Fed instead stand pat.
Holding rates steady on Wednesday could fuel a further selloff in bonds, likely pushing long-term rates higher for longer, if the Fed raises doubts about how committed it is to bringing inflation back to the central
bank's 2% target, these investors contend. Such concerns could fuel further unrest by prompting investors to demand a larger term premium, the extra compensation required to hold longer-dated U.S. debt, particularly as government borrowing needs continue to grow.
"If the Fed doesn't hike, that would put more pressure on the back end of the curve," said Bill Campbell, portfolio manager at DoubleLine Capital, referring to longer-dated Treasuries, those with maturities of 10 years or more.
A rate rise would also help demonstrate the central bank's independence at a time when it faces political pressure to ease policy, Campbell said. That in itself should help contain rates at the long end of the curve, which are already at levels last seen two decades ago.
Markets currently price in a roughly 76% chance of a quarter-point increase this week following a much stronger than expected jobs report and a pickup in consumer prices for August, with 50 basis points of hikes penciled in by the end of 2026. If the Fed does tighten rates, that would mark the first rate increase since July 2023.
Investor attention has increasingly shifted to the term premium embedded in long-dated Treasuries in the face of inflation uncertainty and mounting Treasury issuance to fund fiscal deficits.
FISCAL DEFICITS FUEL INFLATION FEARS
Those concerns are magnified by a U.S. fiscal backdrop that many investors believe is inconsistent with returning inflation to the Fed's target.
Loren Moran, fixed income portfolio manager at Wellington Management, said the recent selloff in bonds reflects more than monetary policy.
Inflation has remained above target for more than five years, oil prices have touched $100 a barrel, federal deficits are running near 6.5% of GDP and economic growth remains strong.
In that environment, she argued that failing to follow through on prior hawkish Fed signals could force investors to reassess how much inflation risk remains embedded in the market.
"What U.S. bond markets are looking for ... is for the Fed to deliver on a more clear action consistent with returning inflation to 2%," Moran said. "That means there needs to be some pain."
She added: "It's clearly very politicized. But the best thing you can do is actually show that you're serious about inflation because that should anchor term premium and ultimately credibility, which has been in question since the July Fed meeting."
BUT OTHERS SAY NOT SO FAST
Not all bond investors agree, however. Some of the largest investors in the market do not believe another rate hike is the solution at this point.
Russell Brownback, deputy chief investment officer for global fixed income at BlackRock, said tightening would place additional strain on already weak rate-sensitive sectors such as housing while doing little to slow areas of the economy that are primarily driving growth.
"I understand the arguments of the hawks on the committee and their desire to remain credibly hawkish as a policy body, but I think there's enough ambiguity or dispersion in the economy," Brownback said.
He dismissed worries about the long end of the curve as overblown.
"For all the consternation and the hand-wringing about the bond market selloff, we came into this year with the long bond at 4.84%, so it's 50 basis points higher with growth having accelerated 400 basis points," Brownback said.
"That's a sign of resilience and where you've had the real repricing is in the front end of the curve related to expectations that the Fed is going to hike."
Other investors said economic resilience could still justify additional rate increases from the Fed.
Lon Erickson, portfolio manager at Thornburg Investment Management, said a measured increase starting with 25 basis points would be reasonable, noting that changes in interest rates typically take six months or longer to fully work through the economy.
"I don't think a 25 basis-point increase is going to crush the economy with all the overall healthy signs and signals we're getting," he said. "We can then sit back and reevaluate as we see data come in over the next several months."
(Reporting by Gertrude Chavez-Dreyfuss in New York; Editing by Colin Barr and Matthew Lewis)
