Red a white warning sign on a fence reading “Caution – vigilante patrolling this area”. … [+]
getty
With inflation back to 1980s levels, it is only fitting that the so-called Bond vigilantes return. Ed Yardeni coined the term in the 1980s to describe the action of bond market investors to demand higher yields in response to monetary or fiscal policy. The Federal Reserve (Fed) and other central banks have gone beyond welcome with their ultra-loose policy and need to tighten aggressively.
inflation
Glenview Trust, Bloomberg
Fed Chairman Powell noted in his press briefing that the job market was “very, very tight” and “tight at an unhealthy level.” The Fed’s dual mandate is employment and price stability, so the combination of inflation and resilient employment is a green light for aggressive monetary tightening. Markets will be watching Friday’s monthly jobs report closely. The unemployment rate is expected to fall to 3.7% while wage growth accelerates to 5.5% yoy. Investors should expect vigilantes to continue to squeeze yields while the labor market remains tight.
unemployment
Glenview Trust, Bloomberg
In theory, the economy should be able to handle a significant number of rate hikes if demand and job growth are on solid footing. In addition, post-inflation real Fed funds rates are only slightly above their all-time lows, even after the recent rate hike. Meanwhile, price shocks from the war in Ukraine pose a significant economic downside risk if prices lead to demand destruction.
Real fed funds rate
Glenview Trust, Bloomberg
Markets are now pricing in a Fed rate hike of over 2.4 percentage points over the next year and a half. That’s nearly ten 25 basis point (0.25%) increases! As a testament to how aggressively markets are regarding the Fed, futures markets are essentially pricing in 50 basis point (0.50%) hikes in May and June instead of the more usual 25 basis points.
Expected Fed rate changes
Glenview Trust, Bloomberg
By the definition of two-year US Treasuries, short-dated bond yields rose ahead of the first rate hike. Yields on short-term bonds have already risen significantly, pricing in aggressive Fed rate hikes. The 2-year rate is not far off pre-pandemic levels. If inflation is moderating and the Fed is not forced to hike more than expected, the short end of the curve has become more attractive. While these rates are still below the current rate of inflation, they are finally above the Fed’s long-term inflation target of 2%.
Two-year US Treasury yield
Glenview Trust, Bloomberg
By the definition of 10-year US Treasuries, longer-dated bond yields have risen rapidly. Two variables are likely to primarily determine the fate of longer-term interest rates, inflation and the strength of the economy. Based on our historical nominal GDP growth and inflation model, the odds favor higher yields on 10-year paper unless the fall in demand negatively impacts these variables.
Inflation, GDP and the US 10-year yield
Glenview Trust, Bloomberg
Stocks continued to rise last week despite the rise in short- and long-term interest rates. In the past, stocks have been able to move successfully through higher long-term yields. Higher interest rates are usually a sign of economic growth, so the positive correlation makes sense. However, periods of higher yields and weak economic growth are not a good recipe for returns from stocks or bonds.
Higher yields usually mean higher stock prices
Glenview Trust, Bloomberg
The Bond vigilantes appear to continue to have their feet in the fire for the Fed to act aggressively and tighten monetary policy in the face of inflationary threats. Short-term bond yields have risen sharply, pricing in aggressive Fed rate hikes. Provided that the price shocks do not manifest themselves in a weakening labor market, the chances should still speak for higher yields and thus lower prices for 10-year government bonds.
Comments are closed.