Bond market succumbs to the inevitability of rate hikes
Markets currently have few certainties, but one stands out: everyone hates government bonds. Fear, disgust, war. † † all that bad stuff normally pushes jumpy investors into the warm, reassuring arms of the world’s safest markets, including major US Treasuries. This time it’s different.
The extent of the confusion among investors is apparent from a note from Pimco this week. The team there agreed that Russia’s invasion of Ukraine, the ensuing sanctions and tensions in commodity markets have “cast an even thicker layer of uncertainty” on an already challenging environment marked by the stop-start recovery. of the Covid-19 pandemic. This is not your ordinary outburst of nerves, said Joachim Fels and Andrew Balls of the bond fund manager.
“Unlike risk, which can be quantified by assigning probabilities to outcomes based on experience or statistical analysis, uncertainty is essentially unmeasurable and represents the unknowable unknowns,” they wrote. “In a radically uncertain environment, detailed point forecasts are therefore not particularly helpful in shaping investment strategy.”
Instead, it makes sense to agree on a broad vision and consider the wide range of possible scenarios and the potential for “non-linearities” and abrupt regime changes in the economy and financial markets. Your keywords there are “non-linear” and “abrupt”. They reflect a widespread expectation that something is likely to go catastrophically wrong – we just can’t say what or when.
Typically, this kind of vague fear and uncertainty would support bond markets well. But one thing investors can agree on with a high degree of confidence is that high and rising inflation has become inevitable and the bond market must adapt. This will be the worst month for US Treasuries, at least since Donald Trump was elected president in 2016.
This week, downward pressure on prices pushed 10-year yields up to 2.5 percent, up the best part of a full percentage point since the start of 2022. Markets and the US Federal Reserve were mired in a stalemate for several weeks around the turn of the year. But the debate is essentially over: the central bank will really push interest rates, despite economic fragility, to face inflation.
It’s not just the US, with its remarkably aggressive central bank, that is at play here. The German 10-year yield, which rarely sees sunlight above zero percent, has risen to 0.58 percent, the highest level since 2018, dragged up by the strong pull of the US market.
“Bonds have performed very poorly,” Axa Investment Managers’ Chris Iggo said in his weekly note. “The first quarter of 2022 is almost over and it has been terrible,” he added, with relapses surpassing the Fed’s previous four rate-raising cycles in 1994, 1999, 2004 and 2015.
At this point, the worst could be over, but “it cannot be ruled out” that yields will increase by as much as one percentage point over the next 12 months, Iggo added. He also said there is a chance they are on the way back to the 4 to 5 percent range that prevailed before the 2008 financial crisis.
The icing on the cake came in the form of a sudden 0.14 percentage point rise in government bond yields on Friday afternoon – a big jump for the measures of this market. The growing idea that the Fed could weather one or more rate hikes of half a percentage point at a time is gaining ground.
Even those who tend to see the advantage of bond prices are changing their tone. Steven Major, global head of fixed income research at HSBC, is one of them.
“In a game of soccer (soccer for our American friends), what seemed like a nailed-down, sure-fire win — based on first-half performance — often turns out not to be so in the second half,” he wrote in a note this week. “Overconfidence, injuries, substitutions, management skills? Whatever the explanation, things happen. † † And so it is with our updated forecasts.”
Major raised his target for the U.S. 10-year yield from 1.5 to 2 percent, and also raised an additional half a percentage point on his forecast for the end of 2023 to 1.5 percent. There was also an acceptance that he should have understood the Fed’s more aggressive stance sooner than he did. Major’s predictions are still well below current levels, and he’s not giving up on the idea that inflation will soon run out or that economic growth could prove too shaky to handle a torrent of rate hikes. Still, when Team Lower-For-Longer starts to wobble, it feels like a moment.
Citi upped the ante on Friday, telling customers it expects four half-point rate hikes from the Fed this year and also two-quarter-point hikes. “The path remains data dependent and stronger or weaker monthly inflation prints could lead to more, [such as half a percentage point] at every meeting or less,” the bank added.
Should you be concerned about this unless you are managing a bond fund? You will if you’re investing in a truly different asset class, as US returns provide a basis for pricing many other assets. The recent surge in yields reminds us that even typically stable markets can break.
katie.martin@ft.com