Treasury bears were forced back into hibernation earlier this year, as US government bond yields remained stubbornly subdued despite faster growth and firmer inflation. But the Federal Reserve is beginning to reawaken the slumbering pessimists as investors prepare for a more active tightening cycle.
The US central bank is set to raise rates for a third time this year on Wednesday, with another increase in December widely expected. But investors are also beginning to gird themselves for the possibility that Fed policymakers will not sit still in 2019 either, as many had until recently expected. And that reappraisal has rattled the market.
“The story of a 2019 Fed pause has gotten banged up,” said Edward Al-Hussainy, a senior strategist at Columbia Threadneedle. “There now seems to be far more market confidence that the Fed will continue to hike.”
This month the 10-year Treasury yield rose cleanly above the 3 per cent mark for the first time since May, and at 3.07 per cent it is now within a whisker of hitting a new seven-year high. The 30-year Treasury yield, known as the long bond, has also climbed sharply this month, to a four-month high of 3.22 per cent.
Should the 10-year and 30-year Treasury yields both close above 3 per cent and 3.25 per cent, it will signal a “game changer” for markets, according to Jeffrey Gundlach, the head of DoubleLine Capital, a big bond investor.
Unlike previous moves in Treasury yields this year, which were primarily fuelled by rising inflation expectations, the recent jump appears mostly driven by a reappraisal of how aggressively the US central bank will tighten monetary policy in the coming year.
The five-year “break-even” rate, a measure of inflation expectations derived from comparing nominal and inflation-protected Treasury bond yields, has nudged higher over the past week, but still remains below its 2018 average. Meanwhile, the yield of the Eurodollar futures contract for December 2019 — a derivative that allow traders to bet on where interest rates are heading — has jumped to a four-year high of 3.15 per cent.
The primary catalyst for the reappraisal was better than expected growth in average hourly earnings in August, but also the notably hawkish comments by several Federal Reserve policymakers that have normally been considered in the dovish camp. Even Lael Brainard, a particularly dovish Fed governor, earlier this month said that more rate increases were warranted given the economic stimulus provided by the Trump administration’s tax cuts.
“I think that wage growth was a wake-up call for a lot of people but it was a series of events that set the market on its ear,” said Bill O’Donnell, a rate strategist at Citi. “It’s that second phase, of doves turning to hawks and talking about restrictive policy, that has the market repricing 2019 hikes.”
The upcoming Fed Open Market Committee meeting could further rattle the market. The Fed is not expected to meaningfully change its forecasts at the upcoming meeting, but the expected rate increase would lift the Fed funds rate — the central bank’s main monetary policy target — above the Fed’s preferred inflation measure for the first time since 2008.
In the event Fed chair Jay Powell and the FOMC’s predictions reinforce the view that the central bank is intent on raising rates at the planned pace it could force an even more meaningful investor reassessment. In turn a renewed bout of dollar strength will restart the emerging market turbulence that has abated in recent weeks.
“The Fed doesn’t need to raise its forecasts, they just need to stress their confidence,” said Mr Hussainy. “If Treasuries then sell off and the dollar rallies then we’ll be talking about emerging market pain again.”
However, some analysts and investors argue that a more hawkish central bank that tightens interest rates more aggressively should instead subdue longer-term bond yields, as it signals that the Fed is acting preemptively to slow growth and forestall inflation. But instead of flattening the “yield curve” — the difference between short and long-term bond yields — the curve has instead steepened sharply this month. Typically, a steeper curve signals stronger growth expectations that risk spurring rising inflation pressures.
“The curve steepening and the belief that the Fed is going to continue to hike next year just doesn’t jive,” said Henry Peabody, a bond fund manager at Eaton Vance. “One of those two things has to adjust.”
The explanation could be a broader investor reappraisal of whether the US economy is merely enjoying a temporary bout of strength, or finally finding another faster gear — as some Fed policymakers are now speculating, and might hint at the upcoming meeting.
And while many investors remain skeptical, Jim Caron, a bond fund manager at Morgan Stanley Investment Management, said that “the market then has to at least price in the possibility of higher potential growth”.
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