Markets have few certainties right now, but one thing stands out: everyone hates government bonds. Fear, loathing, war. . . All of this bad stuff usually drives nervous investors into the warm, comforting arms of the world’s safest markets, chief among them US Treasuries. It’s different this time.
The level of confusion among investors is highlighted in a statement from Pimco this week. The team there agreed that the Russian invasion of Ukraine, the resulting sanctions and tensions in commodities markets have thrown “an even thicker layer of uncertainty” on an already difficult environment marred by the stop-start recovery of marked by the Covid-19 pandemic. This is no ordinary nervous breakdown, said Joachim Fels and Andrew Balls from the bond fund manager.
“Unlike risk, which can be quantified by assigning probabilities to outcomes based on experience or statistical analysis, uncertainty is essentially non-measurable and represents the unknown unknowns,” they wrote. “In a radically uncertain environment, therefore, detailed point forecasts are not particularly helpful when designing the investment strategy.”
Instead, it makes sense to agree on a broad perspective, taking into account the variety of possible scenarios and the potential for “non-linearities” and abrupt regime changes in the economy and financial markets. Your key words there are “nonlinear” 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 nebulous fear and uncertainty would keep bond markets well supported. However, investors can agree with great confidence that high and rising inflation will persist and the bond market will need to adjust. This looks set to be the worst month for US Treasuries, at least since Donald Trump was elected President in 2016.
This week, downward pressure on prices pushed the 10-year yield as high as 2.5 percent, up most of a full percentage point since early 2022. Markets and the US Federal Reserve were in a stalemate for several weeks around the turn of the year. But the debate is practically over: the central bank will indeed raise interest rates to counter inflation, despite economic weakness.
The USA, with its extremely restrictive central bank, is not the only one playing a role here. Germany’s 10-year yields, which rarely see sunlight above zero percent, have climbed as high as 0.58 percent, the highest since 2018, buoyed by the strong pull of the US market.
“Bonds have done very poorly,” Axa Investment Managers’ Chris Iggo said in his weekly note. “The first quarter of 2022 is almost over and it was awful,” he added, with pullbacks topping the Fed’s previous four rate-hiking cycles in 1994, 1999, 2004 and 2015.
At that point, the worst might be over, but “it can’t 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 is a possibility they are on their 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 Treasury yields on Friday afternoon – a big jump by this market’s standards. The growing notion that the Fed could be poised for one or more half a percentage point a pop rate hikes is gaining traction.
Even those who are normally inclined to see the upside potential in bond prices are changing their minds. One of them is Steven Major, Global Head of Fixed Income Research at HSBC.
“In a football game (soccer for our American friends), what seemed like a nailed-down, assured win – based on performance in the first half – often turns out to be not quite so in the second half,” he wrote in a note this week. “Overconfidence, injuries, substitutions, leadership qualities? Whatever the explanation, things happen. . . And so it is with our updated forecasts.”
Major raised its 10-year Treasury yield target to 2% from 1.5% and raised its forecast for the end of 2023 by another half a percentage point to 1.5%. It was also accepted that he “should have grasped” the Fed’s more hawkish stance sooner than he did. Major’s forecasts are still well below prevailing levels, and he’s not giving up on the notion that inflation may soon lose momentum or that economic growth may prove too shaky to sustain a stream of rate hikes. But still, when Team Lower-For-Longer starts to shake, it feels like a moment.
Citi upped the ante on Friday, telling clients it expects the Fed to raise four half-point rates this year and two more quarter-point hikes. “The path remains data dependent and stronger or weaker monthly inflationary pressures could lead to more, [such as half a percentage point] at every meeting or less,” the bank added.
Unless you run a retirement fund, is that something you need to worry about? You do this when you’re invested in virtually every other asset class, as US yields provide a basis for pricing a variety of other assets. The recent jump in yields is a reminder that even typically quiet markets can collapse.