In this case, it has been a quick slide in bond prices and a resulting surge in bond yields that have brought on 2021 with a bang. The yield on the US Treasury 10-year note, an important market benchmark, surged last week to 1.87 percent (its highest since the start of the pandemic) from 1.52 percent at the end of 2021. To put this move in context, some on Wall Street were predicting a jump in yields of that magnitude for all of 2023.
The sell-off in the bond market has been broad-based, with the US Core Bond Index down 2% so far this year. This came on the heels of a 1.6 percent index plunge in 2021, the biggest decline since 2013, when the index fell 1.95 percent. These losses in bonds have rippled over to the stock market and added to its own bumpy start to the year.
The already-rising rates seen in 2021 are no great secret, analysts say. By historical standards, bond yields were extremely low, particularly when set against the strength of the economy and inflation.
“It’s not surprising that we’re seeing rates start to rebound,” said Daniel Kemp, global chief investment officer at Investment Management. Rates “were a long ways from normal.”
But, as with the abrupt reversal in stocks at the start of 2022, the velocity and magnitude of the surge in bond yields unsettled many in the market.
Collin Martin, a fixed-income strategist at Charles Schwab, says that for all of 2022, he expected the 10-year note’s yield to hit a range of 1.75%–2%, “and we are three weeks in and we are already smack-dab in that range.”
Now investors must ask how much of the rise in interest rates is behind them and what the risks are that rates will leap again.
The Fed’s About-Face
Answering begins with last-year’s hot economic recovery, the surge in inflation that was driven by supply-chain and labor market bottlenecks, and the sharp about-face at the Fed, where policy turned on a dime from stomping on the gas pedal to keep the economy growing smooth to hitting the brakes to smother inflation before it becomes entrenched. The Fed now appears on track to hike the federal-funds rate four times in 2022, with the first move possible as soon as March. Only two months ago, expectations focused on two or three rate increases this year beginning in May or June. (Here’s a plain-English explanation of the Fed and what it does.)
A lot will depend on inflation’s trajectory and whether it remains exasperatingly high, or as most analysts think, is at its zenith and will return to more reasonable levels. The risk is that inflation will not fall quickly, or far enough, from the December 7 percent year-over-year gain.
“It’s all about inflation,” says John Briggs, global head of desk strategy at NatWest Markets.
Stubborn inflation would probably force the Federal Reserve to act even more aggressively to raise interest rates than the markets expect it to, which means more rough sailing ahead for the bond market.
And for investors, that means keeping an eye on two fronts of Fed policy. The first is what bond market wonks refer to as the terminal rate, which is the level at which the Fed permanently ceases raising the funds rate. At present that is viewed as about 1.75%, compared to zero now. The second is the timing of what’s known as quantitative tightening, in which the Fed shrinks the amount of reserves in the banking system; it’s the opposite of the bond market purchases that sought to pump cash into the economy during the recession caused by the pandemic.
Schwab’s Martin says that although the firm thinks it’s “probable interest rates don’t move much higher from here” this year, “the short answer is, it’s still too early to assess, and a lot of it will depend on what happens with the bookends to the inflation outlook.”
Understanding Rates
Interest rates are a difficult market for many investors to get their arms around. There’s plenty of jargon, and a lot hinges on the Fed’s obscure inner working. Underlying all of this is the inverse relationship between bond prices and bond yields, and the notion that good news for the economy can be bad news for bonds.
To grasp the sharp about-face in the bond market requires going back to the situation in the late 2021. Investors were slowly realizing that the spike in inflation wasn’t as “transitory” during the early Fall as had been believed. At its December meeting, the Fed indicated it was moving toward a more aggressive stance on combating inflation, and expectations swung firmly toward three rate increases next year.
But then in early January, in releasing the minutes of that December meeting, it was revealed that the Fed was contemplating being far more aggressive in raising rates and sucking support from the economy than investors had understood. Since then, expectations had turned to four rate increases this year.
“There was this idea of, 'hey, we might be behind the curve (when it comes to fighting inflation) if we don’t act sooner,' and that was surprising,” says NatWest’s Briggs. “They’re going to be aggressive here.”
Terminal Thinking
Briggs says that from now on, it will be important to pay attention to what the market expects for where the Fed will stop raising interest rates. For the moment he says interest-rate markets look for the Fed to move the funds rate from zero to about 2% by the end 2023. That probably means seven or eight rate increases, “and that’s pretty low,” Briggs says.
Schwab’s Martin says keep an eye on shifts in those terminal rate expectations for clues as to whether bond yields have moved higher. “Unless those expectations rise well north of 2.25%, we don’t see bonds moving meaningfully higher in the Treasury 10-year yield.”
And those expectations, in turn, rely on the trajectory for both inflation data and the speed with which it heads back down toward the Fed’s long-run 2 percent target.
Mirroring a prediction by chief economist, inflation likely peaked in 2021 when it rose 7 percent, but is still sure to run hot this year at 3.6 percent, partly due to long supply chain runs frozen by the omicron coronavirus variant.
At Schwab, the outlook is similar, says Martin. “We’ve either seen the peak or we feel like we’re close,” he says. One reason that will contribute to keeping inflation rates lower is a purely mathematical one: as this year progresses, the higher base of prices we saw in 2021 will make it increasingly difficult to experience big percentage increases in 2022.
Briggs plans to keep a close eye on the consumer price index reports for the February through April period. If inflation appears to be settling in as close to 3%, he thinks the market may need to reset for a higher terminal rate from the Fed and a higher-yield environment overall. That would kick off a fresh sell-off in the bond market.
Until then, “you may have a kind of period where the markets are literally just waiting to see if inflation is going to come down,” he says.
On the QT
The other key factor is the Fed’s plans to pare its mammoth bond holdings that it built up since the start of the pandemic. Such purchases referred to as quantitative easing inject money into the banking system, which helps keep market rates low. The Fed had already said it will be easing up on its bond purchases, a.k.a. tapering.
Now, Fed officials are considering when they might transition to quantitative tightening the opposite of quantitative easing. There are growing expectations this could happen in the second half of the year. If inflation were to remain hotter than expected, that could hasten the pace of QT. The wild card is what size affect QT has on the bond market.
“Bond markets are being prodded most through massive purchases through the central banks,” says Kemp. “How much of it is the buying actually moving prices and how much of it is simply the signaling from the central banks?”
Kemp observes that one pressure working in the background has been an increase in so-called real yields. These are yields that have been adjusted for the impact of inflation. (Inflation reduces the purchasing power of the steady fixed-interest payments bonds generate.) Real yields have been negative since the start of the pandemic meaning that investors have been willing to take the loss of money, adjusted for inflation, in exchange for the safety of owning bonds.
On one hand, inflation expectations have settled over the last several months as the Fed has made it clear it would pursue a more aggressive policy framework. We can see this in a measure that goes by the unexciting name of the 10-year break-even rate, which is essentially the markets’ forecast for long-term inflation rates.
But a lot of the increase in yields this year can be linked back to a jump in real yields, which reflect investors requiring higher returns once factoring in inflation, according to Kemp. Real yields are negative, but the trend direction seems to have reversed.
For Kemp, this is a sign of importance that relates to Treasury bonds role in most investors portfolios. Inflation is outpacing yields, meaning investors are technically losing money on government bonds. Instead, those bonds act to diversify the portfolio away from stock volatility. The theory is that when stocks crash, bond prices go up. “Why do you own bonds? Most of the time they offer crash protection for equities,” he says.
But when it’s a time of rising real rates historically, the insurance doesn’t work as well, he says. Both stocks and bonds have been falling, as evidenced in recent weeks. Rising real yields can work against holdings in riskier bond categories, too, including investment-grade corporate bonds or high-yield bonds, where cash has been lured by more-attractive yield levels. “This is what real word resides for the investors,” Kemp says.
