By Nicholas Larseninternational banker
On the first trading day of May, bond markets crossed a key threshold: the 10-year Treasury yield hit 3% for the first time since December 2018. It has since climbed to around 3.19% before falling back slightly below 3% towards the end of the month. As such, there is growing belief that yields could continue to rise as the sell-off in bond and equity markets continues unabated.
The sharp rise in prices so far this year means that US inflation has hit 40-year highs, prompting the US Federal Reserve (the Fed) to adopt a more aggressive monetary policy in recent months. In March, rates rose for the first time in more than three years, while another 50 basis point hike was made at the May meeting of the US central bank, the first time a hike has been seen. of this magnitude has been implemented in almost 22 years. The Fed also confirmed that it would reduce its huge stockpile of bonds by $9 trillion starting in June in a major show of power aimed directly at tackling runaway prices. In response, the following day, US government bond yields rose significantly across the spectrum, with 2-year bonds rising eight basis points to 2.71%, 10-year bonds by 14 basis points base at 3.06% and 30-year Treasury bonds. yield jumped to 3.16%, an increase of 16 basis points.
Moreover, a tightening of a similar magnitude is now expected in June, along with further rate hikes until at least mid-2023. While this contractionary cycle may achieve its goal of getting inflation back in line with the Fed’s long-term 2% target, there are growing concerns that such aggressive policy could slow economic growth to an excessive degree – and perhaps even plunge the American economy into recession. With the first quarter having seen the gross domestic product (GDP) contract by 1.4% compared to the previous quarter, there is a good chance that the US economy will once again slide back into recession, especially given the increases of significant rates which are now enacted at the same time as the massive balance- sheet reductions. “What we see is that this is a market that continues to be really concerned about the Fed’s ability to control inflation,” Whitney Sweeney, investment strategist at Schroders, recently observed.
Further yield increases could be on the horizon as the Fed tightens monetary policy to reduce inflation. That said, we have already seen an inversion of the yield curve in March, where the 2-year yield exceeded that of the 10-year for the first time since 2019. Historically, this scenario has almost always meant that a recession was right. at the street corner; indeed, the last time this happened was just before the pandemic, which plunged the global economy into a deep contraction. The most recent inversion therefore suggests that the Fed could overtake monetary policy tightening and send the US economy into negative territory.
Although at just under 3%, bond yields remain low relative to historical levels, they have nonetheless staged a dramatic reversal since the onset of the COVID-19 pandemic, when 10-years were trading as low as 0. .5%. At the time, the monetary environment was much more accommodative, as the Fed cut the federal funds rate to its lower limit of 0-0.25% and racked up billions of dollars in debt through its debt program. purchase of assets in order to revive the economy. The Fed also signaled that it would adopt an “average inflation” policy to allow inflation to rise moderately above its official target to average 2% over a longer period.
But perhaps the Fed has been overly dovish, given that it is now scrambling to contain higher prices, and it looks like the long bull run in the bond market may well have already come to an end. Rising yields now reflect higher inflation expectations that pose a palpable threat to long-term economic growth, with a sell-off in bond and equity markets after the Fed’s May decision indicative of this. worry. Indeed, a Bloomberg index of long-term US government bonds shows it on track for its biggest fall this year since records began nearly 50 years ago.
Adding to this hawkish view, weak labor market productivity data released on May 5 showed worker output had fallen at the fastest pace since 1947, while recent unemployment insurance claims were higher than expected. And with lingering issues such as the Russia-Ukraine war, global supply chain issues and energy price spikes likely to erode consumer demand, yields could continue to rise. for a certain time. The conflict in Eastern Europe, in particular, could prove decisive in pushing yields higher this year. Although Russia seems to be making gradual progress in what it calls its “special military operation”, the United States and the European Union are sending tens of billions of dollars in weapons, security aid and aid humanitarian aid to Ukraine, which strongly suggests that there will be no end in sight to war in the foreseeable future.
Indeed, Scott Minerd, global chief investment officer of Guggenheim Partners, said he believes yields could rise for a generation. “I have to throw in the towel. The long bond bull market is over,” said Minerd, who helps run the $325 billion investment firm, recently. FinancialTimes. “Rather than following sound policy…we decided to raise rates and shrink the balance sheet so the Fed would have credibility on inflation. My worry is that as we turn around and see inflation start to ease, the Fed won’t recognize where the neutral rate is, and eventually we’ll have a crash.
The situation is reminiscent of the 1970s – another period in which the US economy suffered from rising inflation, which hit double digits at one point, as well as two recessions and saw yields Bonds rallied for much of the decade reaching just under 13% by the end of the decade before climbing even further to around 16% in September 1981. the wall street journal. “Even though the Fed has signaled that it will tighten significantly, it hasn’t yet really seemed to lower inflation expectations, not sustainably.”
But while several indicators point to further bond selling that would precipitate further increases in yields, some traders wonder to what extent yields still have upward momentum. After all, government bonds have historically offered investors safety in times of uncertainty, suggesting that investors could start investing in bonds sooner rather than later. “We think the Fed’s hawkish stance is largely priced into equity and bond markets,” Jay Hatfield, managing director of Infrastructure Capital Management, told CNBC on May 5. the 3% zone as retiring global investors with $52 trillion in assets are reallocated to near-risk-free treasuries…. The Chairman’s press conference was very positive as Chairman Powell ruled out a 75 basis point increase and indicated that only two meetings should have 50 basis point increases and then they would reevaluate.
Bank of America (BofA) takes a similar position. “We view the current 10-year level as a compelling location [to buy the debt]. Inflation worries have reached a level of mania or panic,” the bank’s rate strategists noted in mid-April, while watching “extreme” inflows into inflation-protected bonds. “Our forecast indicates that inflation will peak this quarter and fall steadily through 2023. We believe this will reduce the level of panic around inflation and allow rates to come down.”
There is a growing belief that now may be the right time to buy longer-term bonds. “I think it’s too early to call the peak of returns right now,” said Dickie Hodges, who manages a $3.9 billion bond fund at Nomura Asset Management. FinancialTimeson April 21, while acknowledging that he had increased his exposure to long-term bonds as yields continued their upward trajectory. “But central bankers know that a substantial increase in interest rates from these levels will push economies into recession. term are starting to look attractive.