Markets have few certainties at the moment, but one stands out: everyone hates government bonds. Fear, loathing, war . . . all that bad stuff normally pushes jumpy investors into the warm, comforting arms of the safest markets on earth, chief among them US Treasuries. This time is different.
The scale of discombobulation 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 the strains in commodity markets have “cast an even thicker layer of uncertainty” on an already tricky environment marked by the stop-start recovery from the Covid-19 pandemic. This is not any ordinary outbreak of nerves, said Joachim Fels and Andrew Balls at the bond fund manager.
“In contrast to 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 view and be mindful of the wide range of possible scenarios and of the potential for “nonlinearities” and abrupt regime changes in the economy and financial markets. Your key words there are “non-linear” and “abrupt”. They reflect a widespread expectation that something is likely to go disastrously wrong — we just cannot tell what or when.
Typically, this sort 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 has 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 pressure on prices pushed the 10-year yield as high as 2.5 per cent, an increase of the best part of a full percentage point since the start of 2022. Markets and the US Federal Reserve were engaged in a stand-off for several weeks around the turn of this year. But the debate is effectively over: the central bank really will push interest rates higher, despite economic fragilities, to face down inflation.
It is not only the US, with its notably hawkish central bank, at play here. Germany’s 10-year yields, which rarely see sunlight above zero per cent, have cranked as high as 0.58 per cent, the highest since 2018, dragged up by the US market’s strong gravitational pull.
“Bonds have performed very poorly,” said Chris Iggo of Axa Investment Managers in his weekly note. “The first quarter of 2022 is nearly over, and it’s been awful,” he added, with pullbacks that outstrip the previous four rate-raising cycles from the Fed, in 1994, 1999, 2004 and 2015.
At this point, the worst could be over but “it can’t be ruled out” that yields push as much as another percentage point higher over the next 12 months, Iggo added. He also said there was a chance that they are on their way back to the range between 4 and 5 per cent that prevailed before the financial crisis of 2008.
The icing on the cake came in the form of a sudden 0.14 percentage point rise in Treasuries yields on Friday afternoon — a large jump by the standards of this market. The growing notion that the Fed might plump for one or more rate rises of half a percentage point a pop is gaining traction.
Even those typically inclined to see the upside in bond prices are changing their tune. Steven Major, global head of fixed income research at HSBC, is among them.
“In a game of football (soccer to our American friends) what seemed to be a nailed-on, certain victory — based on the first half performance — often turns out to be not quite so in the second half,” he wrote in a note this week. “Overconfidence, injuries, substitutions, managerial skill? Whatever the explanation, stuff happens . . . And so it is with our updated forecasts.”
Major upped his target on US 10-year yields to 2 per cent, up from 1.5, and also slapped an extra half a percentage point on his forecast for the end of 2023, to 1.5 per cent. There was also an acceptance that he “should have grasped” the more hawkish stance from the Fed sooner than he did. Major’s forecasts are still comfortably below prevailing levels, and he is not giving up on the idea that inflation could run out of steam soon or that economic growth could prove too shaky to sustain a stream of rate rises. But still, when Team Lower-For-Longer starts to wobble, it feels like a moment.
Citi upped the ante on Friday, telling clients it expects four half-point rate rises from the Fed this year and two quarter-point bumps too. “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 fewer,” the bank added.
Unless you are running a bond fund, do you need to worry about any of this? You do if you have investments in really any other asset class, as US yields form a bedrock for pricing a host of other assets. The recent leap in yields is a reminder that even typically staid markets can snap.