Bond Market Week Ahead: Stocks Cheer Steady Course In Monetary Policy, But Bond Market Fears Inflation On The Horizon

Following its scheduled policy meeting June 17-18, the Federal Reserve announced that it would continue tapering its QE program. This prompted a rise in equities as investors view the decision as a signal of policymakers' faith in the strength of the recovery.

Fed Chair Janet Yellen took specific efforts to reassure investors that a hike in short term interest rates was not imminent.

However, the bond market sold off last week as investors feared inflation risks are increasing the longer the Fed remains accommodative. The 30-year yield climbed two basis points to 3.43 percent. Benchmark 10-year and two –year notes also fell for the third consecutive week. The 10-year note yield rose less than a basis point to 2.61 percent and the two-year note rose a full basis point to 0.46 percent

More importantly, the dealer and hedge fund community is concerned that the Fed may overshoot in terms of its easy money policy, stoking the flames for longer-term inflation down the road.

Related Link: Benzinga Weekly Preview: Geopolitical Tension Continuing To Weigh On Markets

Treasury five-year break-even rates, which measure the difference between yields on notes and similar-maturity Treasury Inflation Protected Securities(TIPS), were 2.09 percent, the highest in over a year. That is up from just 1.98 percent last week. The same is true of longer dated break-even rates. The 10-year break-even rate widened to 2.27 percent, up nine basis points on the week. 30-year bond break-even rate rose eight basis points points on the week.

The market is beginning to price in an inflation risk premium the longer Fed continues to show reluctance to adopt a less accommodative policy.

Data for last week showed the economy continued to gain momentum and inflation ticked up slightly. Core inflation, which excludes volatile food and energy prices, showed a solid increase in May. Several regional forecasts showed that the manufacturing sector remained strong, while continuing unemployment claims fell for the week to their lowest level since October 2007. Housing starts and building permits declined more than expected in May.

Rates are expected to rise further this week. The Treasury has a full slate of auctions that the dealer balance sheets must absorb.

The Treasury will sell $30B of two-year notes Tuesday, $35B of five-year notes Wednesday and $29B of seven-year debt the next day. Primary dealer balance sheets are already very full, meaning the Treasury may have to pay a higher yield next week to auction their securities.

The primary dealers held $39.8B of Treasury notes and bonds as of June 11, up from $6.2B on May 23 and the most since November 29, according to central bank data. The long positions on dealer balance sheets will force the market to move lower in price and higher in yield to make room for this week's new Treasury supply.

This week features more data on housing, with new-home sales and the Case-Shiller index released on Tuesday. The market will also be watching for news from geopolitical hotspots, particularly Iraq, to see if further tension continues to push up oil prices.