Bond traders are trapped between recession and inflation fears
BOND investors are torn about whether the recent pullback in yields — fuelled by increasing fear of recession — marks an end to the worst Treasury bear market of the modern era, or just a pause.
Treasuries rallied sharply in the past week as Federal Reserve Chair Jerome Powell told US lawmakers that it will be “very challenging” for the bank keep the economy growing as officials raise interest rates aggressively to rein in the steepest inflation in four decades. Yet how soon such a contraction could come — and how painful it would need to be to alter the Fed’s path and cap on Treasury yields — is far from certain. And that’s proving vexing for investors trying to time the bond-market’s bottom.
“It’s a tough time to be a high conviction manager,” said Brandywine Global Investment Management’s Jack McIntyre.
The task has been rendered all the more complicated by Powell’s focus on tightening monetary policy until “compelling evidence” emerges of a pullback in inflation. That creates a risk that the Fed will keep raising its benchmark even if signs pile up that tighter financial conditions are denting output significantly. It could even end up tightening during a downturn if high inflation remains persistent.
Treasuries have been battered badly this year as it became clear that the Fed erred in expecting inflation to subside once the world emerged from pandemic lockdowns, a misjudgment compounded by the spike in commodity prices created by the Russia-Ukraine war. With the central bank now moving to aggressively withdraw its monetary stimulus, a broad index measuring the performance of Treasuries is down nearly 10 per cent despite the recent pullback in yields, far exceeding even the biggest annual losses since the early 1970s.
For the moment, rates are in limbo. The shift in focus to the risk of recession erased the dramatic rise in Treasury yields that had been sparked earlier this month by an unexpected acceleration in inflation readings. That inflationary pressure helped encourage the Fed to raise its benchmark rate by three-quarters of a percentage point in the biggest hike since 1994. The 10-year rate climbed to around 3.50 per cent in the wake of the Fed decision, but has since fallen back to flirt with 3 per cent in the face of recession fears. At the shorter end of the rates curve, meanwhile, traders have drastically scaled back their expectations for where they see the Fed funds rate peaking in 2023. That’s come back to around 3.50 per cent, having been well north of 4 per cent earlier in the month.
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“Inflation fear has evolved very rapidly to recession fear,” said Alan Ruskin, chief international strategist at Deutsche Bank AG.
Whether that growing concern about contraction prompts the Fed to actually halt its tightening, though, is another matter.
Margaret Kerins, head of fixed-income strategy at BMO Capital Markets, identifies 2 broad camps emerging among Fed watchers. There are those that see the Fed pushing on with substantial rate increases that take its benchmark to around 5 per cent, and potentially cutting after that if the economy warrants. And there are those who expect the central bank to take a less hawkish path that would allow it to pause not too far above around 2.5 per cent, a level that’s seen as not affecting growth one way or the other, for several months. For her part, Kerins is more in the latter camp: “The inflation war is the battle du jour for the Fed and nothing else matters.”
Gargi Chaudhuri, head of iShares investment strategy for the Americas at BlackRock, reckons the ability of the Fed to engineer a so-called soft landing “looks slimmer and slimmer”, but it’s too soon to act with much confidence. Shifting into longer-dated Treasuries, which were hit hardest in this year’s sell-off, will need to wait for weaker economic data that drives the market to “price in a higher chance of a recession”, she said.
All this, combined with indications from the Federal Reserve that it will very much be led by the development of data, has investors waiting with bated breath on each major economic release, and there are several to focus their attention in the coming week. High on the list will be the personal income and spending report — which includes the Fed’s favoured measure of inflation, the deflator for personal consumption expenditures — along with the Institute for Supply Management’s widely watched manufacturing measure. The market will also be clued into a series of Treasury note sales in the coming week, with 2-, 5- and 7-year securities all on the auction block, as well as potential end-of-quarter effects on portfolio flows and funding.
Of course, recession alone may not be enough to stop the rot in bond markets if it isn’t accompanied by disinflation. There’s a chance that inflation remains stubbornly above the Fed’s target of around 2 per cent even if growth stalls, creating a potential repeat of the stagflation seen in the 1970s. With that risk in mind, senior managers at Pacific Investment Management have recommended inflation-protected Treasuries, predicting that potentially persistent upside in consumer prices may yet erode the value of traditional bonds.
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