The markets have few certainties at the moment, but one stands out: everyone hates government bonds. Fear, disgust, war. . . all of these bad things normally push nervous investors into the warm, comforting arms of the safest markets on the planet, foremost among which are US Treasuries. This time it’s different.
The extent of the confusion among investors is clear in a note this week from Pimco. The team there agreed that Russia’s invasion of Ukraine, the resulting sanctions and tensions in commodity markets have “cast an even thicker layer of uncertainty” on an environment already delicate marked by the stop-start recovery of the Covid-19 pandemic. This is no ordinary tantrum, said bond fund manager Joachim Fels and Andrew Balls.
“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 the big picture and be aware of the wide range of possible scenarios and the potential for “non-linearities” and abrupt regime shifts in the economy and financial markets. Your keywords there are “nonlinear” and “abrupt”. They reflect a widely held expectation that something is likely to go disastrously wrong – we simply cannot tell what or when.
Typically, this kind of nebulous fear and uncertainty would keep bond markets well supported. But one thing investors can agree on with a high degree of confidence is that high and rising inflation is here to stay, and the bond market needs to adjust. This is shaping up to be the worst month for US Treasuries at least since Donald Trump was elected president in 2016.
This week, downward price pressure pushed the 10-year yield as high as 2.5%, an increase of the best part of a full percentage point since the start of 2022. Markets and the Reserve federal government had been locked in a stalemate for several weeks at the turn of this year. But the debate is effectively closed: the central bank is really going to push interest rates higher, despite economic fragilities, to cope with inflation.
It is not just the United States, with its particularly hawkish central bank, that is at stake here. Germany’s 10-year yields, which rarely see sunlight above zero percent, rose to 0.58 percent, the highest since 2018, driven by the strong gravitational pull of the US market.
“Bonds performed very poorly,” said Chris Iggo of Axa Investment Managers in his weekly note. “The first quarter of 2022 is almost over, and it’s been awful,” he added, with pullbacks that exceed the Fed’s previous four rate hike cycles, in 1994, 1999, 2004 and 2015.
At this point, the worst may be over, but “it cannot be ruled out” that yields will rise by as much as another percentage point over the next 12 months, Iggo added. He also said there was a chance they were on their way back to the 4-5% range that prevailed before the 2008 financial crisis.
The icing on the cake came in the form of a sudden 0.14 percentage point increase in Treasury yields on Friday afternoon – a significant jump by this market’s standards. The growing notion that the Fed might opt for one or more rate hikes of half a percentage point per pop is gaining traction.
Even those who are generally inclined to see bond prices go up are changing their minds. Steven Major, global head of fixed income research at HSBC, is one of them.
“In a game of football (football for our American friends), what seemed like a sure and certain win – based on first half performance – often turns out not to be quite so in the second half. -time,” he wrote in an attention this week. “Overconfidence, injuries, substitutions, managerial competence? Whatever the explanation, things are happening. . . And so it is with our updated predictions.
Major raised its target on US 10-year yields to 2%, from 1.5, and also raised its forecast for the end of 2023 by another half point, to 1.5%. There was also an acceptance that he “should have grasped” the Fed’s more hawkish stance sooner than he did. Major’s forecast is still comfortably below current levels, and he’s not giving up on the idea that inflation may soon run out of steam or that economic growth may prove too fragile to sustain a stream of rate hikes. . But still, when the Lower-For-Longer team starts to falter, it feels like a moment.
Citi upped the ante on Friday, telling clients it expects four half-point rate hikes from the Fed this year and two quarter-point hikes as well. “The trajectory remains data driven and stronger or weaker monthly inflation prints could lead to more, [such as half a percentage point] every meeting or less,” the bank added.
Unless you manage a bond fund, do you need to worry about any of this? You do this if you have investments in really any other asset class, because US yields are a bedrock for the pricing of a whole host of other assets. The recent surge in yields reminds us that even generally frozen markets can crash.