Investors gird for high US Treasury yields as new Fed Chair Warsh battles inflation

(Adds dropped letter 'n' in Hoffmann in 3rd paragraph)

By Gertrude Chavez-Dreyfuss

NEW YORK, May 14 (Reuters) - Investors are bracing for U.S. Treasury yields to stay higher longer, skeptical that incoming Federal Reserve Chair Kevin Warsh will be able to tame inflation stoked by surging oil prices during a prolonged Middle East conflict.

Long-dated yields, including those on benchmark 10-year notes, have spiked as investors demand greater compensation for inflation risk as higher energy prices bite. Higher long-term yields feed directly into borrowing costs across the economy: mortgages, corporate bonds, leveraged loans all become more expensive.

"It's not an understatement to say that inflation has been uncomfortable and above target ... heading on five years now and there's also not directionally a way to reassure investors and give them comfort," said Christian Hoffmann, head of fixed income at Thornburg Investment Management in Santa Fe, New Mexico.

Higher benchmark yields could also present headwinds for U.S. stock prices, as companies and consumers will face higher borrowing costs. This can also weigh on economic growth and corporate profits, while possibly making bond returns more competitive with stocks.

The spike in yields is tied to energy markets, which investors view as the primary driver of price pressures.

"Whatever oil does is where yields are going," said Byron Anderson, head of fixed income at Laffer Tengler Investments in Scottsdale, Arizona.

That scenario has prompted some investors to reduce exposure to longer-duration bonds, with Anderson saying his firm is avoiding the long end almost entirely.

Persistent inflation, he argued, will keep pushing long-term yields higher, potentially driving 10-year Treasuries toward 5%, a level not seen since October 2023. Since the beginning of March, the benchmark 10-year yield has risen by roughly 45 basis points and on Wednesday hit an 11-month peak. It was last at 4.484%.

CHALLENGE AHEAD

Investors say stubborn inflation will challenge Warsh, who may encounter a divided group of policymakers.

"If the first things we hear from him (Warsh) are ... dovish arguments about how the Fed can cut interest rates, I think that's going to be a big problem for the bond market," said Ryan Swift, chief U.S. bond strategist at BCA Research in Montreal.

"That would really risk those inflation expectations breaking out and sort of losing control of the long end of the yield curve and that would be a big problem."

Financial markets expect no change to the Fed's 3.5%-3.75% policy rate target this year.

"As incoming Chairman Warsh rolls up his sleeves to get to work, he has some challenges ahead of him," said Jim Baird, chief investment officer, Plante Moran Financial Advisors, Southfield, Michigan. "The challenge around the inflation picture is that there are a number of factors ... which can't be ideally addressed simply by raising rates. Raising rates isn't going to lower global oil prices."

CURVE SEEN STEEPENING

Some see a steeper yield curve going forward, reflecting expectations that interest rates will remain steady on the front end of the curve, with oil-driven inflation driving a selloff in long-dated Treasuries.

A steepening trend stalled when the Middle East conflict started as investors priced out interest rate cuts this year with stubborn price pressures. However, the curve steepened for the last two sessions, with the spread between 10-year and two-year yields last at 48.50 bps.

Chip Hughey, managing director of fixed income at Truist Wealth in Richmond, Virginia, said the sticky inflation picture reinforces expectations that rates will remain on hold until inflation pressures ease, even as the Fed's next move-whether easing or tightening-remains a subject of debate.

Hughey expects the curve to steepen, anticipating that the Fed eventually shifts toward cuts later in the year. This would pull short-term yields lower while longer-dated yields remain elevated due to persistent inflation and economic resilience.

Laffer's Anderson said a steeper curve makes sense. "I think you'll keep seeing the long end sell off just because you're going to continue to see inflation increase."

Warsh's longer-term policy preferences, particularly his focus on shrinking the Fed's balance sheet and potentially shortening the maturity profile of its portfolio, could also shape the curve. A smaller Fed balance sheet implies a withdrawal of meaningful government demand for Treasuries.

Financial conditions would tighten without the central bank providing liquidity to the market.

Reduced Fed bond purchases would also expand the amount of Treasury supply, which tends to lower bond prices and lift long-dated yields, steepening the curve.

Martin Tobias, U.S. rates strategist at Morgan Stanley, said markets are still trying to understand how Warsh might approach balance sheet policy, an issue that could ultimately influence term premiums and Treasury supply dynamics.

Yet any shift is likely to be gradual.

"It's going to take some time for Kevin Warsh to build consensus," Tobias said.

(Reporting by Gertrude Chavez-Dreyfuss; additional reporting by Sin?ad Carew, Karen Brettell and Lewis Krauskopf; editing by Megan Davies and David Gregorio)