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U.S. Government Two-Year Yield Rises to Highest in Almost a Decade

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07/12/2018 | 11:12pm CEST

By Daniel Kruger

U.S. government bond prices edged lower Thursday, sending the yield on two-year notes to its highest close since July 2008, as investors bet that inflation is growing fast enough for the Federal Reserve to continue raising interest rates.

The yield on the benchmark 10-year note rose for the third time in four days to 2.853% from 2.844% Wednesday. The two-year yield rose to 2.593%, and its gains for the year now exceed its entire 2017 climb. Yields rise as bond prices fall.

The difference between yields on two- and 10-year Treasurys narrowed to 0.259 percentage point, the smallest since August 2007. The dispersion between shorter-term and longer-term rates, known as the yield curve, is a crucial indicator of sentiment about the prospects for economic growth, with wider gaps signalling stronger potential growth.

Longer-term yields pared their increase after the Labor Department said Thursday that the consumer-price index, which gauges what Americans pay for everything from lawn mowers to Canadian bacon, rose a seasonally adjusted 0.1% in June from the prior month. Excluding volatile food and energy components, prices increased 0.2%. Economists surveyed by The Wall Street Journal had expected a 0.2% uptick from May for both the overall index and so-called core inflation.

While the pace of inflation has accelerated this year, investors said that it isn't enough to push bond yields higher because prices are rising at roughly the same pace as wages. For the second month in a row, annual inflation fully offset workers' average hourly wage growth in June. That leaves real hourly earnings flat from a year earlier despite falling unemployment and a generally strong economy.

Investors had expected rising wages to lead to faster consumer spending that would fuel growth and inflation, pushing bond yields higher. Now some say they are concerned that momentum appears to have stalled. At the same time, analysts said the data remains sufficiently strong to allow the Federal Reserve to continue raising interest rates, which is expected to have a further dampening effect on price growth.

The slow pace of inflation-adjusted earnings is a troubling sign, said Christopher Sullivan, chief investment officer at United Nations Federal Credit Union. "Where is consumption growth going to come from if consumers aren't being compensated as they should be at this point in the economic cycle," he said.

The combination of Fed rate increases and sluggish inflation should continue to reduce the dispersion between two- and 10-year Treasury yields, Mr. Sullivan said. He said he has made trades that will benefit from the rise in short-term yields relative to longer-term yields.

Fed funds futures, which investors use to bet on the direction of interest-rate policy, early Thursday showed a 60% probability that Fed officials will raise rates at least two more times this year, up from 54% a week ago, according to CME Group data.

Write to Daniel Kruger at Daniel.Kruger@wsj.com

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