The yield on 10-year Treasuries just struck a 2-year high and Fed funds futures are pricing a near certainty that the Fed hikes in March with more to follow from the Fed and other central banks in 2022. Is that too much?
What’s happening in bond markets?
The US 10-year Treasury yield has just reached its highest since early 2020 and is approaching the widely-watched 2% level.
10-year yields have completed an inverse head & shoulders bottom pattern on the daily lien chart. The implication for the pattern is a new rising trend that could carry yields back over 3%. Should the pattern breakout fail by falling back under the neckline of the pattern (circa 1.5%) - it would imply lower yields with a possible drop back under 1%.
Note bond yields rise as bond prices fall. Investors have been selling government bonds since the summer and the pace of selling has picked up again in the New Year. This selling pressure is forcing the price of bonds down and yields are rising to compensate bond investors for the lower prices.
What are markets pricing in?
The CME FedWatch tool (derived from Feds funds futures) shows markets are assigning the highest likelihood to 3-4 rate hikes this year.
A similar outlook is being priced in for the UK, with the Bank of England expected to hike rates from the current 0.25% to 1.25%.
No rate hikes are currently projected from the European Central Bank or the Bank of Japan.
Why have yields been rising?
There are some economic justifications for selling bonds but the clearest reason is supply and demand. The Federal Reserve has been buying government bonds and mortgage-backed securities as part of its pandemic-era quantitative easing program for almost two years. Now the Fed is withdrawing its support from the bond market by reducing its purchases - and if minutes from the December meeting are to be believed - will soon begin so-called quantitative tightening by selling the bonds and MBS’ on its balance sheet. This missing buyer from the bond market is leaving a disequilibrium and bond investors are now actively front-running the Fed’s selling.
The U-turn in central bank policy is a global phenomenon. Hense bond yields have been rising in Europe and Japan too. The switch to tighter monetary policy is global because the underlying cause for doing so is global inflation.
A bond yielding 0.5%, as 10-year US Treasuries were a few months ago, offers no capital preservation to an investor when the official measure of annual inflation is 7%. You are losing 6.5% of your money per year. In Europe, up until last week, German 10-year bunds had been offering a negative yield, when inflation in Germany was running at over 5% in December. JGBs are still negative-yielding given the sub-1% inflation rate in Japan but have backed considerably from the lows.
In essence, high inflation and lower interest rates wipe out the store-of-value property of bonds.
So rate hikes are a done deal?
Not so fast. Inflation is at decades-high - sitting at levels many traders and investors have never experienced before - but some of the assumptions being built into the expected rate of tightening may not hold true.
Inflation peaking
There is some evidence pointing to prices slowing down. It’s well understood that there are supply-chain disruptions but the effect of those disruptions is in effect a one-off. So while prices will likely not fall to previous levels, inflation will not go on expanding forever because of past supply-side constraints. Also, if the problem is supply-oriented - then rate hikes to curb demand won’t work - and could create stagflation. From the demand side, without ‘Build Back Better’ - less government spending should pull down demand and prices as a result. Lower inflation puts less pressure on central banks to tighten aggressively.
Easing growth
Global economies are switching from recovery to normal levels of growth. For example, the GDP of the United Kingdom has just returned to pre-pandemic levels. Naturally, the high rates of growth experienced during the recovery will moderate. Central banks will be reluctant to hike interest rates in a slowing economy, and slower growth means lower demand, which should also feedback into lower inflation.
Politics
The Federal Reserve sets the tone and in the United States, there are midterm elections in November this year. Cynics (not us, of course) would suggest that Jerome Powell’s hawkish U-turn happened right at about the time of his re-election as Fed Chair. Rising prices are eating into consumer confidence - that last thing President Joe Biden and Congressional Democrats want heading into elections while in power. The President wants lower prices - especially lower gas prices before November and the Fed could play a role in making that happen. At the same time, the electorate doesn’t want their monthly mortgage cost to go up either - and central banks tend to step onto the sidelines during elections.
Takeaways
Bond markets are pricing in a sharp about-turn in monetary policy firstly from the Fed but also across the globe. If inflation continues to rise, this is a distinct possibility but if inflation levels off as economies slow and supply chain disruptions are resolved, the Fed might be minded to keep rates low ahead of mid-term elections and other central banks, which face lower rates of inflation, could follow the Fed’s lead.
