A worrying message from the bond market about the growth of the US economy

crisis and recession

The Corona pandemic prompted the Federal Reserve and the US Congress to pump huge money into the economy in support of families and companies, turning what would have been a devastating crisis into the shortest recession in the United States in its history, but with the United States and other rich countries moving erratically from the emergency, Supply chains have crippled and consumer demand has been hampered, at a time when labor markets are in short supply, and low interest rates have triggered a recovery in the real estate sector, which has led to an increase in house prices and rents.

The central bank keeps a close eye on the movement of money markets, and rising bond yields indicate that market players view inflation as a serious problem (or realize that the Fed sees it as a problem, and each side regularly tries to anticipate the other’s moves).

Inflation has also become a political burden for President Joe Biden, leading him to say that taming inflation is a vital task for the Federal Reserve.

Today, the Fed says it is ready to turn its tide in the opposite direction, by raising interest rates. And he is actually reducing the purchases of bonds, which is another tool of his monetary policy.

raise interest

Bond prices and derivatives trading reveal that the market expects the Fed to raise the overnight federal funds rate by at least 1.5 percentage points this year, and many of the Fed’s global central bank counterparts are following suit.

The return of higher interest rates is expected to reverberate throughout the financial system, affecting all types of borrowers, companies and those who work for them. Here, too, the bond market carries a more accurate message to investors.

In the face of inflation, the Federal Reserve is walking a fine line, and its goal is to control the rise in prices without negatively affecting the growth of the economy.

It seems that the bond markets are not confident that the Federal Reserve can do this, and the pattern we are witnessing now is a sharp rise in the yields of short-term bonds, while the yields of longer-term bonds remain significantly low, in what is known in bond market jargon as the straightening of the yield curve. The economy will slow down in the coming years.

If this trend continues and short-term returns rise to exceed long-term returns, an inverted yield curve will result, which is a strong sign of an impending recession.

new dangers

We’re not there yet, but the professional bond market investors are suddenly talking regarding a different world, with new types of risk.

Anne Walsh, CEO of fixed income investments at Guggenheim Partners, was of the opinion that lower bond yields created risks for investors in mid-2019, as they invested heavily in high-risk assets in search of a reasonable return. . Now she sees inflation and the Fed’s response to it as the first and most important problem.

“To see this kind of sudden inflation with supply chain crises and demographics, we have to go back to the post-World War II reality, we have many of the same elements that set the scene now,” Walsh says. “We are going through a very difficult period for asset managers, especially those Those working in the fixed income securities market, and also for equity and equity investment managers.

Corporate profitability is affected

The risks facing stocks are that higher interest rates reduce the value of future profits for companies, while deteriorating economic activity can reduce their revenues.

This change is costing real money for bond market investors, while Treasuries continue to decline so far in 2022, threatening to record consecutive annual losses for the first time since the early 1970s, according to the “Bloomberg” US Treasury Bond Index. More losses may be achieved in the coming period. In the latest round of monetary tightening, the Federal Reserve raised its key interest rate to 2.5% before ending this round. Some investment managers in bonds believe that raising the interest rate to this rate will not be enough this time.

“There is a view that central banks can control inflation without raising interest rates too high,” says Dan Evasin, global head of investment at Pacific Investment Management. Officials are able to achieve positive results.”

Some Wall Street analysts believe that inflation is so structural and entrenched in the economy that the Federal Reserve will find it difficult to achieve its target without causing serious pain.

step late

Bob Miller, head of fundamental analysis for Americas fixed income securities at BlackRock, says that the Fed “may have no choice in controlling the degree of monetary tightening on a specific scale. “The central bank is making a soft landing and extending the economic cycle? What we fear is that they are late enough in tightening monetary policy, and they should have started six months earlier.”

Of course, many false alarms regarding rising bond yields have surfaced over the past several years, with major bond investors betting on a market crash that never really materialized. Long-time hedge fund investor Paul Tudor Jones, former bond fund manager Bill Gross, and Ray Dalio of Bridgewater Associates are just a few of the group of big investors who in early 2018 predicted a rally imminent and very high interest rates.

Investors in Treasuries ended up at the break-even point during 2018, achieving gains of regarding 7% in 2019, and then 8% in 2020, according to the Bloomberg Index.

prediction game

In part, inflation is a game of expectations, and it may help to tame price increases that Federal Reserve Chairman Jerome Powell has sent a message that he is ready to intervene.

The narrowing of the yield gap between traditional Treasuries and those offering inflation protection – known as TIPS – indicates that investors expect the rate of inflation to decline over the next five to 10 years.

These measures of inflation expectations in the bond market reveal that consumer prices increased by regarding 3% on average, well below their current rates, but exceeding the level of less than 2% in the previous period.

While this enhances some confidence that the Federal Reserve will prevent inflation from breaking out, there is another explanation, which is that it is a sign of the weak prospects for the growth of the US economy in the long term.

Investors may have to cross a bumpy road as market valuations adjust to a world in which inflation is a nagging problem and the Federal Reserve continues to use the brakes on growth.

“It wouldn’t be surprising to see a lost year in the stock market and fixed income securities, and investors might have to get used to a few years of low returns, given asset prices starting from a high point in the market,” says Evasin of Pimco. Basis”.