Yield on 10-year Treasury bills exceeds 4% for the first time since November

Rising yields increase borrowing costs for consumers and businesses and hurt the prices of other investments by providing regular payouts with lower risk. Rising yields rattled major equity indices, with the S&P 500 losing about 2.6% in February.

Bets that inflation would decline quickly stalled a one-year bond rout in November and fueled a rebound in equities. But price pressures persisted, pushing the Fed to hold rates higher for longer than expected.

“We find ourselves in a world where we have to accept that money is going to have to cost more,” said Tim Horan, investment director for fixed income at Chilton Trust. “We are still testing what the 10-year yield peak of this cycle will be.”

The 10-year yield, which helps set rates on everything from mortgages to corporate debt, climbed as high as 4.004% in Wednesday’s session, before ending the trading day at 3.994%, according to Tradeweb. It then rose back above 4% on Wednesday evening. The 10-year yield hit a 14-year high of 4.231% in October.

The yield on a Treasury bond closely tracks investors’ expectations of how the Fed will set rates until the date the bond matures. Last year’s rapid increases led to the largest single-year, 10-year rise in yields ever recorded in data dating back to the late 1970s. Stocks had their worst year since 2008.

Investors have spent much of 2022 wondering how high rates will eventually rise and how quickly. Over the past several months, some of that uncertainty seemed to dissipate as expectations crystallized around a possible Fed rate target of around 5%, with some investors betting that a reversal in policy – cuts rates – could follow later in 2023.

Now that prospect faces new tests. The Fed’s rate target, now at 4.5% to 4.75%, is approaching the 5% level that officials still thought in December would be high enough to control inflation. But the latest economic data has indicated that is not yet the case.

In early February, data from the Labor Department showed that unemployment had fallen further at the start of 2023, potentially extending upward pressure on wages.

Then, last week, the latest release of the Fed’s favorite inflation gauge, the Personal Consumption Expenditures Price Index, showed price increases accelerating again in January. Goldman Sachs economists wrote on Monday that they no longer believe PCE inflation will fall below 3% this year.

“The employment situation and the wage situation have been much stronger and much stickier than people thought,” said Ben Santonelli, portfolio manager at Polen Capital Credit.

As well as sending stock prices plummeting, the recent rise in yields has begun to trickle down to other debt markets, such as the junk bond market where Mr. Santonelli invests. This increased the yield offered by bonds rated below investment grade. It also increases these companies’ borrowing expenditures and, at the margin, threatens to undermine the trading conditions of weaker companies, he said.

Even though the 10-year yield rose in February, the two-year Treasury yield, which is particularly sensitive to Fed rate expectations, rose even faster. It ended Wednesday at 4.887%, down from 4.795% on Tuesday afternoon.

A situation in which short-term Treasury bills offer higher yields than longer-term bonds is known on Wall Street as an inverted yield curve. Long-term treasury bills generally yield more than short-term notes to compensate investors against the risk of future unexpected bouts of inflation and interest rate hikes. Reversals often signal to investors that a recession is on the way, as they imply that they expect the Fed to cut rates in the near future to cushion the slowing economy.

With a premium of nearly 0.9 percentage points, the two-year Treasury note hasn’t yielded much more than the 10-year note since October 1981, according to Dow Jones Market Data.

Behind the reversal are growing bets that, with strong economic data, rate cuts are less and less likely in the near future. A month ago, derivatives traders were very confident that the Fed’s target rate would end 2023 below 5%, but now futures markets are pricing in a 9 out of 10 chance that rates will end above 5% December.

Nonetheless, some investors who believe high interest rates will be temporary have increased their holdings of Treasuries. Mohit Mittal, managing director of Pacific Investment Management Co., said the portfolios he manages took the recent drop in Treasury prices as an opportunity to buy more longer-term government debt.

Market-based forecasts show investors still expect the 12-month inflation rate to fall to nearly 3% this year from 6.4% in January. If so, that would make real yields — government debt yields, adjusted for inflation — unsustainable, Mittal said.

“An economy as heavily leveraged as the US economy is unlikely to take real returns like this for an extended period,” he said. “At some point, the expectation is that the Fed will have to cut back.”

Write to Matt Grossman at matt.grossman@wsj.com